What is an IRA?
IRA stands for an individual retirement account. It’s basically a savings account that gives a big tax break for taxpaying individuals to save money for the future. Many people mistake IRAs for investment; it’s technically an investment account you set up.
Think of it like a basket that you store your stocks, bonds, mutual funds, etc. If you compare IRAs to 401(k)s, they are totally different. 401(k)s are accounts provided by your company while IRA is an account that you open up on your own.
In IRAs, you add money to the account over time and use it to purchase investments, and eventually, the money in the account can be taken out once you hit the designated retirement age.
Types of IRAs:
There are two types of IRAs,
1. Traditional IRA
2. Roth IRA
The main difference between the two is when you pay income taxes for the money you deposit.
1. Traditional IRA
This is a good choice if you think your current tax rate is higher than the tax rate you’ll have in
the future, at the time of retirement. This way the money you put in won’t be taxed until you
withdraw it in the future, traditional IRA offers an upfront tax break. For example, let’s say your
income is $40,000 and you contribute $5,000 to an IRA, the amount of your taxable income will
be $35,000.
2. Roth IRA
This is a good choice if you think that the future individual tax rate will rise and be higher than
the current tax rate you have right now. In retirement, the amount you withdraw will not be
taxed at all since you’ve already paid taxes when you made the contributions.
For example, let’s say your income is $40,000 and you contribute $5,000 to an IRA, the amount of your taxable income will still be $40,000 and when you withdraw the $5,000 at retirement you won’t have to
pay taxes.
There are plenty of other types of IRAs such as self-employed IRA, nonworking spouse IRA, small business owners’ IRA, etc. Each addresses the different needs of individual taxpayers. Each type of IRA has its own limitations and penalties too, for example, penalties for when you withdraw money before you hit the designated age of retirement.
With a Roth IRA, they are more flexible when it comes to withdrawing money compare to the Traditional IRA. With Roth IRA, you can leave money in the account for as long as you want but with Traditional IRA, you have to start taking money out as soon as you reach age 70 ½.