Individual retirement accounts provide a means for working taxpayers to set aside a portion of their earnings toward their retirement years in tax-advantaged accounts. There are two primary types of individual retirement accounts: Roth IRAs and traditional IRAs. Both types of IRAs offer specific but different tax advantages. One of the obvious advantages of a traditional IRA, also called a deductible IRA, is your ability to deduct all or part of your contributions when you file your federal income tax return.
The most prominent feature of a traditional individual retirement account is your ability to deduct all or part of your contributions from your income when you file your taxes. This feature may be particularly attractive to you if you are in the midst of your earnings years and are in a high tax bracket because it will reduce the amount of current income on which you are taxed, which will reduce your current income tax obligation. You will be taxed on your contributions when you withdraw the funds, usually after you retire when you will presumably be in a lower tax bracket.
The growth of all funds inside a traditional individual retirement account occurs on a tax deferred basis. None of the growth is taxed until you make a withdrawal. Since you do not pay taxes on the earnings as they are received, you have more money in your account that can continue to grow. Funds in a tax-deferred traditional IRA will grow faster than the same funds is a similar account that is not tax deferred.
Investment Return Treatment
The growth of all investments inside a traditional individual retirement account are treated the same for income tax purposes. This means you don't have to worry about what kind of earnings your investments are generating, regardless of whether your earnings come from interest, dividends or capital gains. None of the earnings are taxed as long as they remain in the account. All of your funds, regardless of how they were earned or contributed, are taxed as ordinary income once you withdraw them from your traditional IRA.
You can set up your deductible IRA any time during the tax year. You can also set up your IRA after the beginning of the next tax year and make deductible contributions to your IRA all the way up to your original filing due date, which is typically April 15. This grace period can help you determine if you need to take advantage of the tax-deduction feature of a traditional IRA. If you find that you already have plenty of tax deductions, you may consider contributing to a Roth IRA, which does not provide a tax deduction, but allows your qualified earnings to grow tax free.
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