Individual retirement accounts (IRAs) provide an excellent option for funding your retirement due to their numerous tax advantages. They are typically administered by a financial institution such as a bank, broker/dealer, trust company or insurance company, which acts as the trustee for the account. There are many types of IRAs, including SEP IRAs, SIMPLE IRAs, rollover IRAs, traditional IRAs, and Roth IRAs. The two most common types of IRAs are Roth IRAs and traditional IRAs, which I will review in detail here. Each of these retirement savings vehicles has its advantages and disadvantages from a tax perspective. Which one is more advantageous for your particular situation will depend on a variety of factors, including your age, time horizon, income (and tax bracket), investment objectives, and expected income and tax bracket in retirement. In most cases I believe a Roth IRA provides a greater benefit overall, however I will review in detail the advantages and disadvantages of both of these retirement savings vehicles in this article.
*Deduction subject to phaseout limits if you have a retirement plan at work
For both the traditional IRA and Roth IRA, an individual may contribute up to $5,500 under the age of 50 and up to $6,500 if age 50 or over in 2017. However, an individual may not contribute more than their employment income. Roth IRA contributions are also subject to income limits. While traditional IRAs do not have income limits, you may not be able to deduct contributions if you or your spouse have a retirement plan, such as a 401(k) or 403(b) plan, at work. (For related reading, see: IRA Contributions: Eligibility and Deadlines.)
Traditional IRA – Tax Deduction Now, Pay Taxes Later
As long as you are not subjected to certain income phaseout limits, traditional IRA contributions are tax deductible in the year in which they are made. You will, however, have to pay ordinary income taxes on the withdrawals. You will also be subjected to a penalty if you make withdrawals prior to age 59.5 (unless you qualify for certain exceptions). Money invested in a traditional IRA grows tax deferred, so you will not have to pay taxes related to the growth or income in the account until you start taking withdrawals. You can make contributions to a traditional IRA up until age 70.5, after which point you will need to take a required minimum distribution each year (this is true for SEP and SIMPLE IRAs as well). The amount of the required minimum distribution increases each year based upon your age according to mortality tables in the IRS code. The required minimum distribution rule makes it difficult for the account holder to continue to grow the account after age 70.5 as funds must be withdrawn from the account every year, thus subjecting these funds to income taxes.
Even if you do not qualify to take a deduction for your traditional IRA contribution, you can still benefit from its tax deferral feature. However, you may be better off making a contribution to a 401(k) plan instead, as you will be able to deduct your contributions there up to the limit. (For related reading, see: 5 Secrets You Didn't Know About Traditional IRAs.)
Roth IRA – No Tax Deduction Now, Withdraw Tax-Free Later
Roth IRA contributions are not deductible in the year in which they are made. However, Roth IRA withdrawals are not taxed as long as the Roth IRA has been in existence for at least five years and withdrawals are taken after age 59.5 (if either of these criteria are not met, the earnings on the Roth IRA are subject to a 10% penalty tax). Roth IRA contributions can be made at any age, and there are no required minimum distributions as there are with a traditional IRA. These features make the Roth IRA a very attractive choice for retirement because the account holder is able to keep the funds in the account for an extended period of time, where they can continue to grow and compound tax free. The account holder has the option to withdraw portions of the Roth IRA assets to fund retirement, and is able to do so tax-free, but is not required to.
(For more from this author, see: Are You Eligible for IRA Contributions Based on Your Income?)
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