IRA stands for Individual Retirement Account and is a way for investors to save for retirement in a tax efficient way. Many different tools for retirement saving exist. It is paramount that investors choose the right one for them personally.
For example, two popular types of IRAs include Traditional IRAs and Roth IRAs. They serve similar purposes, however, have a different means of achieving that purpose.
Additionally, money contributed to a Traditional IRA is tax deductible. For example, if an investor contributes $2,000 to his IRA, the IRS does not apply income tax to those earnings. Capital gains in the account are tax free as well. This is helpful in several ways. First, it lowers the tax burden on the individual, essentially putting more money in his pocket. Second, it incentivizes people to save for retirement, which is always a good thing. However, these contributions are taxed as income upon withdrawal.
Conversely, Roth IRA contributions are not tax-deductible. Meaning one pays taxes on the earnings, then places them in the Roth account. However, as the account appreciates, the earnings are not taxed as capital gains. Additionally, the funds are not taxed upon withdrawal.
Contribution Limitations Of IRAs
Unfortunately, governing bodies limit the annual allowed amount in these accounts. The cap on these IRAs is $5,500 or $6,500 if over 50 years of age. This ensures the system maintains integrity. Savvy investors may trade frequently in these accounts in order to get the tax benefit. These rules keep the playing field level.
Which Account Is Right For You?
Furthermore, choosing the right type of account saves money in the long term. How is this possible? Traditional IRAs make sense if you believe your current tax rate is higher than the tax rate you’ll face in retirement. Essentially, you get a tax break when your burden is highest.
Conversely, Roth IRAs make sense if you are in a lower tax bracket now than in the future. Keep in mind contributions here come from after tax dollars. For this reason, withdrawals are tax-free, leading to greater benefit in the future.