What’s the difference between an IRA, a ROTH IRA, and a Qualified Plan?
All taxpayers must include distributions (minus the cost (basis) from certain retirement plans or annuities into their gross income. But it gets complicated after that.
The IRS treats the distributions of the amount initially put into an IRA as a return of principal, which is not income, so there are no taxes to pay.
Distributions from Roth IRAs are not taxed as income when distributed.
Let’s take a deeper dive into this misunderstood area of the tax code.
WHAT IS A QUALIFIED RETIREMENT PLAN?
The term qualified retirement plan has a wide-ranging meaning within the tax code. Generally, the term describes plans that qualify for reduced or eliminated tax on the distributions or contributions.
A qualified retirement plan is an employer-sponsored retirement plan that satisfies requirements for special tax treatment under §401(a). These plans are called ERISA-qualified plans. ERISA stands for Employee Retirement Income Security Act, which was passed in 1974. ALL employer plans must follow the minimum standards set forth in ERISA.
Other terms used to describe these plans include a qualified employee plan or simply a qualified plan. There are two standard types of qualified plans:
- Defined contribution plans like a profit-sharing or a 401(k).
- Defined benefit plans like a pension plan.
Different rules apply to each plan. Employers establish these plans and can make contributions for the benefit of employees. Some plans allow for deferrals of salary. This is where an employee can contribute pre-tax compensation to the plan rather than receive the amount in their paycheck. Contributions to the plan are generally not included in the employee’s taxable income until withdrawn.
INDIVIDUAL RETIREMENT ACCOUNT (IRAS)
An individual retirement account(IRA) is an account set up for a taxpayer and his beneficiaries. A taxpayer creates this account with a written document that shows ALL of the following requirements:
- The trustee or custodian must be an entity approved by the IRS.
- Contributions, except for rollover contributions, must be in cash.
- The taxpayer must always have a non-forfeitable right to the money.
- The account holder cannot use money in the account to buy a life insurance policy.
- The account holder cannot use money in the account to buy collectibles other than the gold or silver coins minted by the Treasury Department or certain gold, silver, palladium, or platinum coins and bullion.
TRADITIONAL IRA
A traditional IRA (sometimes called a regular IRA) is an IRA that is not a Roth IRA. A traditional IRA can be an individual retirement account or annuity.
Two advantages
of a traditional IRA are:
- Traditional IRA contributions can be tax-deductible.
- Amounts in a traditional IRA, including earnings and gains, are not taxed until distributed. Usually, the effective tax rate (ETR) in retirement (because of a reduction in income) is lower than the ETR when working full-time.
Money cannot remain in a traditional IRA indefinitely, and eventually, a taxpayer must take the required minimum distribution (RMD). The taxpayer generally must make annual withdrawals from most types of retirement plans when reaching age 72.
ROTH IRA
A Roth IRA is an individual retirement plan that must follow the same rules as a traditional IRA, with the following exceptions:
- Contributions to a Roth IRA are not tax-deductible. The tax must be taken out before the funds are contributed to the ROTH.
- There is no required mandatory distribution. The total amount can remain in the Roth IRA until the taxpayer dies.
Two advantages of a Roth IRA over a traditional IRA are:
- Amounts can remain in a Roth IRA; RMDs are not required.
- Amounts in a Roth IRA, including earnings and gains, are generally not taxed, EVEN WHEN DISTRIBUTED.
ROTH CONVERSIONS
A taxpayer can withdraw part or all of the assets from a traditional IRA and reinvest them in a Roth IRA. The amount withdrawn and converted to the Roth IRA is known as a conversion contribution. The additional 10% tax on early distributions will not apply if properly rolled over.
The taxpayer must roll over the same property in the traditional IRA into the Roth IRA. However, the taxpayer can roll over part of the withdrawal into a Roth IRA and keep the rest.
Generally, the amount kept will be taxable (except for the part that is a return of the original contribution) and may be subject to the 10% additional tax on early distributions.
The IRS treats the converted amount as a TAXABLE distribution in the year of the conversion. A taxpayer recognizes the entire amount of the conversion (other than the original basis) in income. A taxpayer may convert a traditional IRA into a Roth IRA, regardless of filing status or income.