You can choose two types of individual retirement accounts: a Roth IRA or a traditional IRA, each allowing different tax advantages. You can also save your money in a non-IRA account, which offers none of the tax advantages of an IRA. However, an account that's not an IRA allows you more flexibility with your money, both in how you invest it and in your ability to withdraw the funds.
IRAs enjoy tax-deferred status regardless of whether you have a traditional IRA or a Roth IRA. This allows your investment to grow without paying income taxes on the gains. With a Roth IRA, the growth is completely tax-free, as you will never pay taxes on the money when you withdraw it. With a traditional IRA, you will pay tax at your normal income rates when you eventually take disbursements from the account, but you can still take advantage of the tax-free growth for many years. With a non-IRA account, you must report the income on your tax return and pay taxes each year on your earnings.
Although a Roth IRA does not offer any tax deduction for your contributions, a traditional IRA allows qualifying taxpayers to take a deduction for their contributions. If you can deduct a $5,000 contribution and you're in the 25 percent tax bracket, you will save $1,250 in taxes. In addition, saving in an IRA might earn you a tax credit, particularly if you are a lower-income taxpayer. A non-IRA account offers no tax deductions or credits.
An IRA is intended for long-term savings toward retirement. If you withdraw from a traditional IRA before age 59 1/2, you will owe taxes on the money your withdraw at your normal income rate, plus a 10 percent penalty. With a Roth IRA, you can withdraw your contributions at any time without taxes or penalties, but you lose the benefits of tax-free compounding of that money if you withdraw it for an emergency. Non-IRA accounts, such as savings accounts and money market mutual funds, work better as emergency funds because they offer quick access.
If you need to pay for your children's college education, or to make a down payment on a first home, you can use some funds from your IRA for these items without penalty, although taxes might be due. A non-IRA account allows you to save without touching long-term retirement savings.
An IRA restricts you to certain types of investments, and your account must be overseen by a custodian or trustee. A non-IRA account does not require you to answer to a trustee, and it is easier to make your own investment decisions.
Capital Gains Differences
With a traditional IRA, withdrawals are taxed as normal income. Sale of assets that gain value, such as growth stocks or precious metals, might result in lower taxes if they are held outside a traditional IRA. If you withdraw $20,000 from your traditional IRA and you're in the 25 percent tax bracket at retirement, you will pay $5,000 in taxes. If you sell a stock that has gained $20,000 in value and you've owned it for more than one year, you will pay only the capital gains tax rate of 15 percent, or $3,000. Again, withdrawals of earnings from a Roth IRAs are not subject to any taxes or penalties when taken at retirement, as long as the account has been open five years or longer.