IRAs: Advantages, Disadvantages and Which One is Right for You

The individual retirement account (IRA) was created decades ago as defined benefit pension plans were declining. The IRA became more popular as workers started to take control of their own retirement savings. The IRA offers individuals an opportunity to save for retirement in a tax-advantaged account.

The traditional and Roth IRA accounts are the most popular types of IRAs. The rules which govern these investments vary. By understanding the top IRA rules for both traditional and Roth IRAs, you'll be prepared to enjoy the benefits of these investment opportunities. (For more, see: Can You Buy Penny Stocks in an IRA?)

Tax-Free Growth

Both the Roth and Traditional IRAs offer tax-free growth. This means that once the money is in the account, there are no taxes levied on the dividends or capital gains that the investments earn.

Both also have the same contribution deadline. You are allowed to contribute to your IRA during the entire calendar year and up to April 15 of the following year.

The Roth IRA account contributions are made with after-tax dollars. In most cases, the traditional IRA contributions can be deducted from your income, although if you are covered by a workplace retirement plan, there are certain limitations.

The deductibility of the IRA accounts are determined by income levels as well as whether you are covered by a workplace retirement account. The IRS explains the IRA deductibility rules for 2015 as follows for those workers who are covered by a workplace retirement account:

If Your Filing Status Is...

And Your Modified AGI Is...

Then You Can Take...

single or
head of household

$61,000 or less

a full deduction up to the amount of your contribution limit.

more than $61,000 but less than $71,000

a partial deduction.

$71,000 or more

no deduction.

married filing jointly or qualifying widow(er)

$98,000 or less

a full deduction up to the amount of your contribution limit.

 more than $98,000 but less than $118,000

 a partial deduction.

 $118,000 or more

 no deduction.

married filing separately

 less than $10,000

 a partial deduction.

 $10,000 or more

 no deduction.

If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the "single" filing status.

If you’re not covered by a workplace retirement account, the contributions to the retirement plan are deductible in most cases. (For related reading, see: Inherited IRA and 401(k) Rules Explained.)

Contribution Amounts

IRAs have strict contribution limitations. To contribute to an IRA, you or your spouse need earned income. For 2015, the maximum contribution amount per person is $5,500 or $6,500 if you’re age 50 or older. After you reach age 70.5, you can’t contribute to a traditional IRA, although you may still add to the Roth IRA. But if your income exceeds a certain level, you may not be able to contribute to a Roth IRA.

2015 Roth IRA income requirements:

Filing Status

Modified adjusted gross income (MAGI)*

Contribution Limit

Single individuals

< $116,000

$5,500

≥ $116,000 but < $131,000

Partial contribution (calculate)

≥ $131,000

Not eligible

Married (filing joint returns)

< $183,000

$5,500

≥ $183,000 but < $193,000

Partial contribution (calculate)

≥ $193,000

Not eligible

Married (filing separately)**

Not eligible

$5,500

< $10,000

Partial contribution (calculate)

≥ $10,000

Not eligible

Source: Fidelity.com

You can invest in a wider range of investments through your self-directed IRA. You may invest in all sorts of traditional financial assets such as stocks, bonds, commodities, mutual funds, even real estate or peer-to-peer lending is available through some investment company custodians.

According to IRS.gov, you may not invest in life insurance or collectibles such as artwork, rugs, antiques, gems and stamps, etc. (For more, see: How Do You Calculate Penalties on a 401(k) Early Withdrawal?)

Penalties

Since the IRA is a retirement investment, there are certain penalties if you take out your money before retirement age. With the traditional IRA, you face a 10% penalty on top of the taxes owed for any withdrawals before age 59½. The same requirement holds true for the Roth IRA except under certain specific circumstances: as long as you’ve held the Roth IRA for five years and reached age 59½, you can withdraw your money penalty-free. You’ll only owe taxes on any earnings from the account, since you funded it with pre-tax money.

The Roth IRA offers several early withdrawal opportunities. The most popular include:

  • You may withdraw up to $10,000 to help pay for your first home.
  • You may withdraw from the Roth IRA funds to pay for college expenses for yourself, your spouse, children or grandchildren.      

Required Withdrawals

A popular benefit of the Roth IRA is that there is no required withdrawal date. You can actually leave your money in the Roth IRA to let it grow and compound tax-free indefinitely.

There are mandatory withdrawals for your traditional IRA called required minimum distributions (RMD), when you reach age 70½. The amount of the withdrawal is calculated based on your life expectancy with a 50% penalty, plus taxes owed if you fail to take the RMD. (For more, see: Best Ways to Avoid RMD Tax Hits on IRAs.)

The Bottom Line

The Roth and traditional IRAs are easy to set up with assistance from any discount or standard investment broker. Both have their advantages and disadvantages. Know the rules for what many consider to be stellar retirement vehicles and check the IRS.gov website for regular changes and updates. (For more, see: Avoid Mistakes in the Required Minimum Distributions.)