IRA’s In The Nutshell

What’s an IRA?

An IRA or Individual Retirement Account is a personal savings account that allows workers to save for retirement in a tax efficient manner.  Any individual who receives earned income in a given year can contribute up to $5,000 in an IRA (click here to see how much you’re eligible for).  Within an IRA, individuals can hold all types of investments including stocks, bonds, CD’s, mutual funds and REITS.  

Traditional IRA Vs. Roth

There are two types of IRA’s: Traditional IRA’s and Roth IRA’s. Traditional IRA’s give workers a tax break up-front.  They allow you to deduct any contributions you make from your taxable income each year.  This helps lower your tax bill as Uncle Sam subsidizes your retirement.  With a traditional IRA, your contributions will grow tax-free until retirement.  Upon turning 59 1/2 you’ll be eligible to begin withdrawing money from your IRA.  The money you withdraw will be taxed at your ordinary income tax rate.

The second kind of IRA is called a Roth IRA.  Roth IRA’s don’t give individuals an up-front tax break like traditional IRA’s do.  Instead, Roth IRA’s let investors have a tax break on the back-end by giving them tax-free withdrawals in retirement.  Here’s how it works… a person works and earns taxable income.  They pay the appropriate taxes on their income and then fund their Roth IRA out of pocket. The Roth IRA is then permitted to grow tax-free until retirement.  Upon retirement they can withdraw any amount they choose each year and not pay any income taxes.

Which Should I Chose?

Let’s assume that you’re eligible to contribute to both a traditional or a Roth IRA.  Which should you choose?

If you can do without the up-front tax break, I’d suggest opening a Roth IRA.  Roth IRA’s are more flexible because they allow you to withdraw your contributions anytime with out penalties.  They also don’t subject you to mandatory distributions at age 70 1/2.  

I’d suggest opening a traditional IRA if you need that tax deduction this year or if you believe you’ll be in a lower tax bracket in retirement.

The Bottom Line

The bottom line with IRA’s is that they are extremely powerful tools when it comes to saving for retirement.  Both offer investors tax efficient shelters for their retirement investments.  A 25 year old can expect to accumulate a nest egg of over $1.5M for their retirement just by maxing out their yearly contributions.  Whether you chose the up-front tax deduction of the traditional, or the tax-free withdrawals of the Roth, contributing to an IRA is one of the smartest ways to ensure a secure retirement.  

In a future post I’ll be providing instructions on how to open an IRA… so stay tuned.