What is an IRA?
An IRA is an account set up at a financial institution that allows an individual to save for retirement with tax-free growth or on a tax-deferred basis. The two main types of IRAs; each have different advantages:
- Traditional IRA – You make contributions with money you may be able to deduct on your tax return, and any earnings can potentially grow tax-deferred until you withdraw them in retirement.1 Many retirees also find themselves in a lower tax bracket than they were in pre-retirement, so the tax-deferral means the money may be taxed at a lower rate.
- Roth IRA – You make contributions with money you’ve already paid taxes on (after-tax), and your money may potentially grow tax-free, with tax-free withdrawals in retirement, provided that certain conditions are met.
The biggest difference between a Roth and a traditional IRA is how and when you get a tax break. The tax advantage of a traditional IRA is that your contributions are tax-deductible. The tax advantage of a Roth IRA is that your withdrawals in retirement are not taxed.
In other words, with a traditional IRA, you pay taxes when you take distributions in retirement (or if you make withdrawals prior to retirement). A Roth IRA operates in reverse: You pay taxes upfront, because your contributions are not deductible. Earnings on your investments grow tax-free in a Roth and tax-deferred in a traditional IRA.
Why invest in an IRA?
Many financial experts estimate that you may need up to 85% of your pre-retirement income in retirement. An employer-sponsored savings plan, such as a 401(k), might not be enough to accumulate the savings you need. Fortunately, you can contribute to both a 401(k) and an IRA. An IRA can help you:
- Supplement your current savings in your employer-sponsored retirement plan.
- Gain access to a potentially wider range of investment choices than your employer-sponsored plan.
- Take advantage of potential tax-deferred or tax-free growth.
You should try to contribute the maximum amount to your IRA each year to get the most out of these savings. Be sure to monitor your investments and adjustments as needed, especially as retirement nears and your goals change.
What are the Contribution limits?
Both traditional and Roth IRAs come with eligibility rules and restrictions that determine how much you can contribute. Assuming you’re eligible for both, you can contribute to a traditional and a Roth IRA during the same year, as long as the total amount does not exceed the maximum allowable contribution limit of $6,000, or $7,000 if you’re age 50 and over.
The amount you’re allowed to contribute to a Roth IRA, however, isn’t an all-or-nothing scenario — it’s a “heck, yeah!” “sorta” and “sorry, not this year, cowboy” scenario. Roth contribution limits are based on household income, and those at higher incomes often find themselves squeezed out of Roth eligibility either partially or completely.
There are no income restrictions for contributing to a traditional IRAs — titans of industry and everyday workers alike are eligible to open and contribute up to the annual limit — but your income can affect how much of your IRA contribution you’re allowed to deduct from your taxes.
In addition to the size of your paycheck, traditional IRA deductibility takes into account tax filing status and whether you and/or your spouse are covered by an employer’s retirement plan.
It’s generally not a good idea to withdraw money from an IRA early, and the rules do a good job of deterring it: You must be at least age 59½ to avoid early withdrawal penalties and taxes. But sometimes dipping into your retirement savings is unavoidable.
When you take money out of a traditional IRA before retirement, the IRS socks you with a hefty 10% early-withdrawal penalty and taxes the money you take out as income at your current tax rate. The Roth has better terms for those who break the seal on the retirement savings cookie jar: It allows you to withdraw contributions — money you put into the account — at any time without having to pay income taxes or an early withdrawal penalty. However, there are different rules when it comes to accessing the earnings from your Roth IRA: That money is subject to the five-year rule that states that any earnings withdrawn before your first Roth IRA contribution is at least 5 years old may be subject to income taxes and a 10% early withdrawal penalty.