How Do IRAs Work?
An IRA is an account you put money into that receives favorable tax treatment. Each year, you can elect to contribute money to your IRA using out-of-pocket money. This is opposite to your 401k contributions, which must be funded through payroll deductions. There is also an annual contribution limit. If you exceed this limit, penalties will be applied, as your contributions are reported to the Internal Revenue Service (IRS) by your IRA provider. In most cases, you must open your own IRA.
What Are The Different Types of IRAs?
While IRA plans come in a large variety, there are two main types.
- Traditional IRAs, which reduce your taxable income if you are under a certain income limit. Since you contribute to an IRA with taxed money, you can claim a deduction at the end of the year. After you are refunded for your traditional IRA contribution, this money becomes tax-deferred. What this means is that you will pay income tax on your contributions and your earnings at your marginal tax rate when you take distributions from your traditional IRA from then on.
- Roth IRAs, in which your contributions have already been taxed at your current marginal income tax rate. In exchange, earnings may be distributed tax free, so long as the distribution meets age and eligibility requirements.
Which IRA Should You Choose?
There are many factors based on accounts and plans when it comes to choosing which IRA is best for you. However, there are also two main categorical factors that you absolutely must consider.
- Income. Qualifying high earners tend to be better off contributing to a traditional IRA. This allows them to avoid paying their current high marginal tax rate. Conversely, those with lower incomes favor the Roth IRA, as they can pay a low marginal tax rate now in exchange for never being taxed on that money again. Take the time to look at your marginal tax rate and weigh each option accordingly.
- Future income tax rates. While there is no way of being certain about your future income tax rate, some can venture a guess based on their finances. Those who believe they will be in a lower tax bracket when they retire favor the traditional IRA if they qualify for deduction. Because they will end up at a lower tax bracket, those taxable deductions will be lower. However, those who believe they will be in a higher income tax bracket when they retire tend to favor the Roth IRA. This way, they can pay a lower initial tax and get their deductions without being additionally taxed. Those who believe income tax rates will rise across the board choose Roth IRAs for this same reason.
IRAs seem daunting, but they are all about crunching those income tax numbers. Take the time to do the math and speak with your IRA provider before choosing which type of IRA is right for you.
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