A tax-advantaged Individual Retirement Account (IRA) is a great way to save for retirement. It can provide tax deductions, the potential for tax-sheltered long-term growth.
There are two primary types of IRAs: traditional and Roth. One or the other may be right for you, depending on your circumstances. Both traditional and Roth IRAs let your retirement savings grow tax-deferred. But there are several key differences that might make one more appropriate for you than the other.
Traditional IRA—Contributions to a traditional IRA are tax-deductible depending on your income and whether you participate in an employer-sponsored plan such as a 401(k). Your earnings can grow tax- but are taxed as ordinary income when you withdraw them.
Roth IRA—There’s no up-front tax deduction for a contribution to a Roth, but you can withdraw the earnings income tax at age 59 ½ if you’ve held the Roth for five years. There are also maximum income qualifications for contributing fully to a Roth IRA that vary from $105,000 for singles to $178,000 if you’re married filing jointly for the 2013 tax year.
How to decide
Consider a traditional IRA if you qualify for the up-front deduction and think your tax bracket will be much lower when you retire than it is today.
You likely want to use a Roth IRA if you think your tax bracket will be higher when you retire—an important consideration if you haven’t yet reached your peak earning years.
Beginning in 2010 (and beyond), everyone, regardless of income, is eligible to convert all or a part of a traditional IRA to a Roth IRA. You pay taxes on the amount converted, but after that, no taxes are due. This conversion can make the most sense if you believe that you will be in a higher tax bracket when you eventually withdraw the funds.
What you can contribute
If you have earned income, you can contribute up to the maximum annual contribution. Annual contribution limits are the same for traditional and Roth IRAs:
Currently, you can contribute a maximum of $5,500.
If you’re 50 or older, you can make an additional $1,000 catch-up contribution for a total of $6,500.
When you can withdraw your money
To discourage people from withdrawing their money too early, there are taxes and penalties associated with early withdrawal, depending on the type of IRA.
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