Individual Retirement Accounts, or IRAs, are savings accounts with features that limit the amount of taxes you pay on your savings, making them great financial instruments for saving for retirement. IRAs allow you to invest the money that you have saved into stocks, bonds, mutual funds and other assets so that your money would grow more quickly than in a traditional savings account that earns interest from the financial institution holding the account.
There are several types of IRAs a person can hold, but most people choose the two most common types: the traditional IRA and Roth IRA. Both of these types of IRAs have slightly different rules and operate in slightly different ways.
Tax Benefits
The main difference between a Traditional IRA and a Roth IRA is when you must pay income taxes on the money in the plans. Contributions to a traditional IRA are made with pre-tax dollars, limiting the amount of taxes paid in the years that contributions are made. Withdrawals from a traditional IRA are taxed during the retirement years, allowing contributors to manage their tax amounts by limiting the amount that they withdraw from the plan each year.
Contributions to a Roth IRA are made with after-tax dollars, meaning that the money has already been taxed before it is contributed to the account. This allows the contributor to make withdrawals during their retirement years tax free, unless the money is withdrawn before you have reached the age limit for the withdrawals. In both cases, the money grows tax free in the account until it is withdrawn for other purposes.
Income Limits
While almost anyone with earned income can contribute to a traditional IRA, there are income limits for contributing to a Roth IRA. The income limits for a Roth IRA are less than $167,000 if you are married filing jointly, less than $105,000 if you are single, head of household, or married filing separately and did not live with your spouse for the previous year. If your income is higher than the income limits, you can still contribute to a traditional IRA up to the maximum contribution amounts.