Investing and saving for retirement is an essential step toward a financially secure future, and an Individual Retirement Arrangement (IRA) is the most common way to start saving.
IRAs also offer potential tax benefits for your 2018 federal tax return, up until April 15, 2019. You can defer paying income tax on as much as $5,500 that you contribute to an IRA. Individuals age 50 and older are permitted to contribute an additional $1,000 to an IRA, increasing their tax deductions. IRAs provide one of the only tax deductions available after the end of the year.
There are several different types of IRAs, but the most common are the traditional IRA and the Roth IRA.
With a traditional IRA, your earnings and deductible contributions grow tax-deferred. This means that you won’t have to pay income taxes on your earnings and contributions until you begin taking distributions, usually after you retire. You are required to begin taking distributions from a traditional IRA by April 1 following the year in which you turn 70½.
The requirements for opening a traditional IRA are simple: if you are younger than 70½ and have earned income, you can open and invest in one of these accounts. Withdrawing money, however, is a little more complex.
You may withdraw money from a traditional IRA at any time, but in most cases there will be a 10 percent early withdrawal penalty if you take money out before age 59½. There are some exceptions to the early withdrawal penalty; generally, you may withdraw from a traditional IRA penalty-free before age 59½ in order to buy your first home, pay for higher education or certain significant medical costs, or because of disability or death. These withdrawals would still be subject to taxes.
There are no income limits established in order to contribute to a traditional IRA, while a Roth IRA has certain income limits that must be met.
A Roth IRA enables you to accumulate earnings on a tax-deferred basis and withdraw earnings tax-free for qualified distributions. With this type of account, you are able to withdraw contributions at any time without a penalty, and there is no requirement to start taking distributions at a certain age, like there is with a traditional IRA. However, if you withdraw earnings before age 59½, and before you’ve held the Roth IRA for five years, that money will be subject both to income taxes and a 10 percent early withdrawal penalty.
Unlike a traditional IRA, contributions to a Roth IRA are not tax-deductible. This rule requires you to pay taxes upfront but allows you to enjoy tax-free withdrawals during retirement.
In both types of accounts, earnings on investments grow tax-free, and you can convert a traditional IRA to a Roth IRA later if you wish.
The traditional IRA and the Roth IRA each have their own benefits and disadvantages, depending on your financial situation.
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This information is not legal or tax advice. Information is from sources deemed reliable. Information is subject to error, omission, withdrawal, or change. Contact your own tax advisor before taking any action that would have a tax consequence.