IRA Terms Explained

 

Individual Retirement Arrangements, more commonly known as IRAs, are investment vehicles you can set up on your own to save for retirement.  There are several IRA terms to understand when reviewing the features and rules for this type of account. 

To start, let’s outline the two main IRA terms — traditional IRA and Roth IRA — before covering the other concepts. 

Traditional IRA: Depending on your income, you might be able to deduct contributions to traditional IRAs (see deductible definition below). You can still contribute to a traditional IRA if your income is too high, but your contribution will not be deductible. When it’s time to withdraw money from a traditional IRA, you only pay taxes on amounts that have yet to be taxed. 

Roth IRA: Unlike a Traditional IRA, you can never deduct contributions to a Roth IRA. Additionally, if your income is above certain limits, you can’t contribute to a Roth at all.  Roth IRAs have a unique rule, called the five-year rule, which states that your contributions must be in the account for five years before you can withdraw earnings tax- and penalty-free. Additionally, you must be at least 59 1/2 to withdraw earnings tax- and penalty-free. 

This information is just a quick overview of both types of IRAs. For details on both accounts, review these articles:

Additional IRA Terminology

Money going in, money going out. What’s deductible and what’s taxable for IRAs? And what about moving money from one account type to the other? We’ll answer these questions in our IRA terminology explanations below.   

IRA Terms: Money You Put In or Take Out of Your Account

Contribution: This is money you put into an IRA account. There are annual limits on the amounts you can contribute to IRA accounts. The limits are the same for traditional and Roth IRAs. 

For 2019, contributions are limited to the lower of these:

  • Your compensation (wages and net self-employment income)
  • $6,000 (or $7,000, if you’re age 50 or over)

Deductible contribution: Deductible means you can deduct your contribution on your return. Any deductible contribution reduces your taxable income. Deductible contributions are fully taxed at the time of distribution. Deductible IRA contributions only apply to traditional IRAs and not Roth IRAs, so you might hear the “deductible IRA” term used to describe a traditional IRA. 

Nondeductible contribution: A nondeductible contribution doesn’t affect your taxes the year you contribute as long as it’s not an excess contribution. Nondeductible contributions are made from after-tax funds. So, when you take a distribution, the original contribution amount won’t be taxed.

Distribution: This is money you take out from an IRA account. Other IRA terminology you might hear for this is “withdrawal.” This includes any amount you convert or roll over. You’ll receive a 1099-R from the custodian of your IRA (the financial institution holding the money) that shows this amount. Also, there will be one or two distribution codes shown in Box 7. You’ll use these to determine the taxability of your distribution.

IRA Terms: Moving Money from One Account Type to Another

Conversion: Specifically, this means changing a traditional IRA to a Roth IRA. When you contribute to a traditional IRA, you have the option of moving your contributions to a Roth IRA. You might want to do this if your income is too high to contribute to a Roth IRA directly. This is sometimes called a back door IRA.  

If your traditional IRA is a deductible IRA, the conversion will be taxable (see deductible below). If it’s a nondeductible IRA (you didn’t take a deduction), the converted contributions aren’t taxed. However, any earnings you convert will be taxed.

Recharacterization: This is when you change a conversion contribution you made to a traditional IRA into a Roth IRA contribution (or vice versa). If you recharacterize a conversion contribution, the IRS treats it as if you had made your original contribution into the more recent form of IRA. Because of the Tax Cuts and Jobs Act of 2017, you can’t recharacterize a conversion contribution from a Roth IRA to a traditional IRA from Jan. 1, 2018, to Dec. 31, 2025.

Rollover: This is the nontaxable transfer of the funds from a retirement plan into another retirement plan. Ex: If you leave a job, you can withdraw money from your 401(k) and deposit it into an IRA. It’s like you’re doing a distribution and a contribution at the same time.

There are two ways to roll over your retirement plan money:

  1. A rollover can be a direct transfer from the custodian of one plan to the custodian of the other, usually by an electronic funds transfer (EFT). The first custodian could also send a check to the other to do the rollover.
  2. You can withdraw the funds from your old plan by check or with an EFT to one of your bank accounts. Then, within 60 days, you’ll need to deposit the money into your new plan.

There are drawbacks to the second method, which is also known as a indirect rollover. The withdrawal is likely subject to a tax withholding of 20%. So, to make this a tax-free rollover, you must deposit the 80% remaining funds plus enough from your own funds to make up for the amount withheld. If you only deposit the 80%, you’ll be taxed on the 20% tax withholding. If you’re under age 59 1/2, there will be an additional 10% penalty for early withdrawal.

You can make a rollover back into the same IRA account that you withdrew the funds from.

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