American investors have several choices when it comes to how to save for retirement. These choices include IRA accounts, 401(k) accounts, pension plans and more. An IRA account is a simple way to save for retirement on either a pre-tax or after-tax basis depending on the type of IRA used. There are two basic types of IRA, a traditional and a Roth.
A traditional IRA can provide some potential tax advantages. The funds deposited in a traditional IRA may be fully or partially deductible, and gains made in the account grow tax-free until distributions are made.
A traditional IRA account must be held by a custodian which could be a bank or brokerage. These different custodians may allow for various types of assets to be purchased and held within the IRA account. For example, a brokerage may allow you to buy stocks or mutual funds, a bank may offer certificates of deposit and a self-directed IRA custodian may allow for access to precious metals or real estate.
The biggest potential benefit of a traditional IRA account is the fact that the funds can grow tax-free until they are distributed. If you own stock, for example, you may earn dividends. Those dividends may be reinvested to purchase more shares and increase earnings from dividends. A traditional IRA account puts the awesome power of compounding to work for you. Because no taxes are being paid on the funds, you have a greater amount of funds to invest and work for you over the years.
Once you reach the appropriate age and begin taking distributions from your traditional IRA account, those distributions will be subject to federal income tax.
Like a traditional IRA account, a Roth IRA may allow the investor to purchase and gold various asset classes such as stocks, bonds, mutual funds, real estate and more. The primary difference between a traditional IRA and a Roth IRA is that contributions to a Roth are not tax-deductible. Distributions on contributions from a Roth IRA may, however, be withdrawn tax-free and penalty-free if appropriate guidelines are followed.
A Roth may be beneficial if you believe you will be paying a higher tax rate in retirement than your current rate. A Roth may also be considered by those who are looking to minimize their tax liability in retirement or who may want to leave their assets to heirs upon their death.
Both traditional IRA accounts and Roth IRA accounts have numerous rules and guidelines that must be carefully followed and complied with. Failure to do so could result in taxes and penalties and a loss of tax-deferred status on assets.
Navigating the world of retirement savings vehicles can be tricky and it is always best to consult with your tax professional when it comes to retirement planning and tax related questions. Other than making sure you set up the appropriate account type, the most important thing is to begin saving sooner rather than later to maximize the power of compounding.