Being able to live the lifestyle you want in retirement often depends on saving consistently over many years. An individual retirement account (IRA) can be a powerful tool in this effort. Most IRAs offer tax benefits that encourage long-term retirement savings, along with a variety of investment options, including mutual funds and annuities.
The most common types of IRAs held by individual investors are traditional IRAs and Roth IRAs. Here's what you need to know about each type of retirement account to determine which may be best for you.
With a traditional IRA, you may be eligible for a tax deduction on some or all of the contributions you make each year, assuming you meet eligibility requirements. In practical terms, this means both income taxes on the money you use to fund your account and taxes on any gains in your portfolio invested in your IRA are delayed until they are withdrawn.
If you wait to withdraw funds until you turn age 59½, the IRS will tax your withdrawals as ordinary income. If you withdraw your money earlier, however, you may owe an additional 10% withdrawal tax. Additional taxes may be exempt for qualifying events. For example, withdrawals up to a certain amount for buying your first home, or to cover death, disability or certain medical expenses.
Roth IRAs differ from traditional IRAs in one key way: The contributions you make to a Roth account are with money that has already been taxed. The benefit to this setup comes later, during retirement, when you can withdraw your retirement savings tax-free.
There are a couple of additional caveats with Roth IRAs. First, to qualify for tax-free withdrawals, you need to hold your investments in a Roth IRA for more than five years. Second, the IRS limits the amount you can contribute to a Roth IRA if your taxable earnings exceed its contribution limits in a given year; some taxpayers with high taxable income will not be able to contribute at all. Third, Roth IRAs impose the same 10% tax for withdrawals before age 59½, as do traditional IRAs. With a Roth IRA, however, you'll also have to pay taxes on any investment earnings if you make an early withdrawal that's not covered by one of the exemptions mentioned above.
Which is right for you?
The major difference between traditional and Roth IRAs involves when you pay taxes. Looking at your income today and comparing it to what you expect to receive in retirement could help you choose the right type of account.
For example, if you expect your income in retirement to be lower than it is now, you might consider a traditional IRA to shelter some of your current income from taxes. In this scenario, your withdrawals in retirement would likely be taxed at a lower rate, too.
Conversely, if you're early in your career, a Roth IRA may help you stretch your future retirement savings. If years of compound growth result in significant investment gains, tax-free withdrawals could represent a substantial savings over a traditional IRA.
Since investments and taxes can be difficult to predict, you should consult a financial professional to discuss whether a Roth or traditional IRA would be a good fit for your particular financial needs.
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