Are There Two Types of IRA?
Saving for retirement can be an ambitious goal, and IRAs can help you reach it. Traditional IRAs allow you to contribute pre-tax dollars, which grow tax-deferred until age 59 1/2 when they will become taxed as withdrawals.
IRAs can hold most forms of publicly traded securities as well as nontraditional assets like real estate; however, custodians may impose further restrictions on which investments they accept.
Tax-deferred
Tax-deferred IRAs allow investors to save and grow their investments without paying annual income taxes, which allows funds to compound in an account that’s exempt from annual taxes – this has the potential to yield impressive long-term returns, though withdrawals from such accounts will still be taxed as ordinary income. Such accounts include traditional individual retirement accounts (IRAs) and 401(k) plans.
Contribution limits for these accounts are set by the IRS and may change annually, while many workers also benefit from potential employer matches on their 401(k) contributions. Certain health savings accounts offer tax-free growth potential; however, early withdrawal penalties from such accounts (before age 59 1/2) may incur penalties from the IRS; an advisor can help you choose an IRA type most suitable to you.
Tax-free
Tax-free IRAs allow you to withdraw funds without paying income tax and penalty fees; however, you must be at least 59 1/2 years old in order to do so. Withdrawals made before this age may incur income taxes as well as an early withdrawal penalty under IRS rules unless an exception applies.
There are two types of tax-free IRAs: traditional and Roth. Both allow you to deduct contributions; the difference lies in how earnings are taxed; traditional IRAs offer tax-deferred growth while Roth IRAs allow for withdrawals tax-free at retirement time.
Your choice of an IRA should depend on both your current financial circumstances and future goals, and which tax bracket you anticipate being in upon retirement. A traditional IRA might make more sense for someone expecting to be in a lower tax bracket at retirement; conversely a Roth IRA may prove more valuable for someone expecting higher taxes in later life.
Tax-deductible
IRAs allow your investments to grow tax-deferred until retirement; then withdrawals are taxed. However, the IRS restricts how much can be deducted by considering factors like income and access to an employer-sponsored retirement plan; contributions can only be deducted up until April 15 – usually an IRA contribution cannot exceed this deadline.
To qualify for a traditional IRA, you must have earned income, such as wages reported on a W-2 form, tips, self-employment earnings or alimony payments. Unfortunately, not everyone can contribute to one since their compensation may exceed what can be contributed.
Nondeductible IRAs offer another viable investment solution, although without all the same tax advantages of a Roth or deductible IRA. Instead, these accounts allow you to invest your pretax income without being subject to brokerage account rules – however withdrawals will incur taxes but penalties can be waived after age 59 1/2 as long as certain requirements have been fulfilled.
Withdrawals taxed
IRAs are an effective way of saving for retirement. But before making withdrawals from an IRA, it is important to carefully consider their tax implications. Most withdrawals will incur income taxes; however, there may be certain exceptions such as using funds in an IRA for purchases up to $10,000 and qualified educational expenses.
Traditional IRAs may be suitable for people expecting to retire into lower tax brackets; however, a Roth IRA could make more sense in that situation.
Another option available to small business owners and self-employed individuals is the Savings Incentive Match Plan for Employees IRA (SIMPLE IRA). SIMPLE IRAs offer similar flexibility as SEP IRAs but allow employees to contribute via salary deferral instead. They’re easier to set up and manage, offering another viable choice when saving for retirement.
Categorised in: Blog