IRAs can be an effective way to help fund your retirement. Contributing to an IRA can also provide a number of important tax advantages, both during the years in which you make contributions, as well as in the future. The most common types of IRAs are the traditional IRA and the Roth, each of which offers unique tax benefits.
Lower Taxable Income
With a traditional IRA, you fund the account with pre-tax dollars. This means that some or all of your annual contributions can lower your taxable income and you may owe less in federal income taxes during years in which you contribute. The amount you can deduct depends on factors such as your income level and whether you (or your spouse, if applicable) are covered by an employer-sponsored retirement plan like a 401k.
A traditional IRA also offers tax-deferred growth, meaning you do not pay taxes on earnings until you begin to withdraw money at retirement. For many people, their income is lower after retirement, and they may also be in a lower tax bracket. As a result, the amount of taxes owed on IRA distributions may also be lower. The tax-deferred feature also means that a traditional IRA can prove to be an effective tax shelter during your working years.
Unlike a traditional IRA, you fund a Roth IRA with after-tax dollars, so there is no upfront deduction when contributing. However, a key benefit of the Roth is that you can receive tax-free distributions upon retirement. If it appears that you'll be in a relatively high tax bracket when you retire, tax-free distributions can be a major benefit to you. As with the traditional IRA, you won't pay taxes on Roth earnings as they accrue over time.
From a tax standpoint, your decision whether to contribute to a traditional IRA or a Roth can depend upon factors such as how much of a current tax break you need and how concerned you are about paying taxes after you retire. Also keep in mind that you can contribute to a Roth and a traditional IRA in the same year, as long as your total contributions do not exceed the allowable limit, which is $5,000 if you're under age 50 and $6,000 if you're 50 or older as of the time of publication.
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