IRA - Traditional...Roth...what is this about?

You may have heard me mention the term IRA in some of my past posts. Even if you don't know what it means, you have probably determined that it is 1. a good way to invest your money for the future and 2. something you don't want to think about until ten years from now. Let me explain it to you and hopefully next time you hear someone talking about it you will be able to chime in intelligently.

IRA - Individual Retirement Account

The government has setup this retirement savings program to encourage people to save for retirement before it is too late.

This year, if you are age 49 or below, you can contribute up to $5000 of your own money into your IRA account (up to $6000 if you are 50 or above). This account can be set up with most any financial institution. Each year, the maximum amount that can be deposited into your account increases due to inflation. Once you put money into your IRA you cannot withdraw the funds until you reach the age of 59 1/2. There are a couple circumstances where you can withdraw earlier than that (if you become disabled or want to contribute up to $10,000 toward a residence), otherwise you will face an early withdrawal penalty.

The advantage for a traditional IRA is that any money you pay into your account is tax-deductable. If you put in $5000, you will only pay income tax on your annual income minus the $5000. Once you put the money into your IRA, it is up to you on how you want to invest it. You can use it to purchase specific stocks, mutual funds, or other investments. Once you begin withdrawing your funds after the age of 59 1/2, you will then be required to pay taxes on those funds.

The Roth IRA is different in that you put money into the account that you have already paid income taxes on. You can still make your own decisions on how you want to invest your money until you begin withdrawing the funds. The advantage of the Roth IRA is that you don't need to pay any taxes on your profits when you retire.

The best way to determine whether you should do a traditional IRA or a Roth IRA is to consider the tax bracket you are in now compared with the tax bracket you see yourself being in when you retire. The more money you make, the higher your tax bracket will be. And most people intend to make more money in the future than they do today. That said, the Roth IRA is becoming a more popular choice, especially among younger people.

If you are wondering why you would want to put this money into an account you can't access for decades, think about how it would work if you just put your money into a regular investment account. If you invest your money in a basic money market account (non IRA) you will have to pay income tax on your profits every time you sell a stock or mutual fund. Over the course of many years, all of the money paid to the IRS would have added up to a lot if you were able to reinvest it.

It takes a lot of discipline to save an extra couple thousand dollars every year, but if you can do so, and make that money work for you, you will be happy in the end.