An Individual Retirement Account (IRA) is an investment tool that allows individuals to save for retirement in a tax-advantaged way. It can hold many types of assets including stocks, bonds, mutual funds, and others. Where a 401(k) is generally provided by the company that one works for, the most common types of IRAs are accounts that an investor can open on their own.
IRAs do have eligibility restrictions, based on income and/pr employment status, so they are not available for everyone. It is also important to note that the money invested in an IRA is penalized if taken out before the designated retirement age, and there are caps on how much can be contributed each year. There are two types of IRAs that are commonly used by investors- the Traditional IRA and the Roth IRA.
The Traditional IRA
The Traditional IRA is a tax-deductible avenue to save for retirement. An investor can claim the money contributed to an IRA as a deduction on their income tax return. When the returns are withdrawn in retirement they are taxed as income. An important component that distinguishes a Traditional IRA from a Roth IRA is that the Traditional allows individuals to direct pre-tax income towards investments that can grow tax-deferred.
Individual taxpayers are allowed to contribute 100% of earned compensation to a Traditional IRA, up to $5,500 for the year 2017. If the account owner is 50 years or older, they can add up to an additional $1,000.
If the investor contributes to a retirement plan through their workplace (such as a 401(k)), they may not be able to contribute to a Traditional IRA. The benefit of a Traditional IRA is that when an investor reaches retirement they may find themselves in a lower tax bracket, therefore the money saved in the IRA could be taxed at a lower rate than if it was taxed when it was first invested.
The Roth IRA
The other common type of IRA is a Roth IRA. This is a similar retirement vehicle, but the contributions, and any growth, are tax free. Many Roth IRAs have the same contribution limits as Traditional IRAs. Roth IRAs differ in that they allow contributions of earned income after the age of 70.5, whereas the Traditional IRA does not. The contributions made to a Roth IRA are not tax deductible, but they are tax and penalty free after the age of 59.5.
Investors may choose a Roth IRA with the expectation of being in a higher tax bracket later in life. An investor contributes to a Roth IRA with after-tax dollars, but as the account grows there are not any taxes on capital gains, and the withdrawal from the account in retirement does not incur income tax. Again, the contributions are from money that an investor has already paid taxes on, but the money may potentially grow tax-free with tax-free withdrawals in retirement.
The Traditional and Roth IRA have distinct advantages depending on age and income. The tax benefits of either help savings to grow and/or compound more quickly than in a regular taxable account. These are a sound option for investors looking for a good way to save for retirement. If there are any further questions on investing in an IRA, please contact us at [email protected].