An IRA is a tax-favored investment account. Money in the account can be invested in many different vehicles ranging from money market accounts to stocks. The most common types of IRAs are Traditional and Roth.
Traditional: Pay taxes later
If you’re in a high tax bracket now, consider a Traditional IRA, because contributions (invested money) are tax deductible. Income will likely be lower during retirement, so distributions (withdrawals) will be taxed at a lower rate. Here are some details:
• Anyone under age 70 1/2 who earns income can contribute.
• Distributions made before age 59 1/2 are subject to a 10 percent penalty.
• Deductible contributions may be reduced if you’re covered by a work retirement plan.
Roth: Pay taxes now
Most young people are in a low tax bracket, so a Roth IRA may be a better choice. With a Roth you pay income tax before contributing, and distributions aren’t taxed. This means that you’ll pay taxes when you’re younger and in a lower tax bracket, rather than paying higher taxes later when you’ll likely be in a higher tax bracket. Here are some details:
• Anyone who earns income can contribute as long as adjusted gross income is less than $120,000 (single) or $176,000 (married filing jointly).
• To withdraw distributions without penalties, a Roth IRA has to be open for at least five tax years and you must be at least 59 1/2 years of age.
Both Roth and Traditional IRAs have exceptions that allow for penalty-free withdrawals. These include some education expenses and first-time home-buying expenses. If you’re unsure which type of arrangement to choose, consult with a financial professional.
IRAs can be opened through financial institutions, brokers or mutual fund companies. Keep in mind that the contribution limit for an IRA varies by year — the 2016 limit was $5,500 for people under the age of 50. IRAs can be actively or passively managed: either take charge and pick specific investments based on research, or have an account manager make those decisions.
Start now, because every year that slips by is another missed opportunity to compound interest and make your money grow.