The IRS designed the individual retirement arrangement with several tax advantages to help Americans save for retirement. There are two types of IRA, with different benefits: the traditional IRA and the Roth IRA. When you invest in a traditional IRA, it reduces your adjusted gross income. Investments in the Roth IRA don't lower your adjusted gross income, but instead give you better tax benefits in the future.
When you put money in a traditional IRA, the entire qualifying contribution can be deducted from your adjusted gross income. This gives you a tax break today, while also putting money aside for the future. In addition, the traditional IRA delays taxes on your investment gains. As long as you keep your money in the traditional IRA, you won't owe any tax on your earnings. When you take money out of your traditional IRA, the entire withdrawal is taxed as income.
You need to fund a Roth IRA with after-tax dollars. This means your Roth IRA contributions won't reduce your adjusted gross income. In exchange, your investment gains in the Roth IRA are completely tax-free. When you take money out of your Roth IRA in retirement, you won't owe anything to the IRS.
The IRS limits the amount you can invest per year in an IRA. As of 2012, you can invest up to $5,000 a year total into your IRAs. If you are 50 or older, you can invest up to $6,000 a year. This limit applies to the combination of both types of accounts. If you put your full annual investment into a traditional IRA, you won't be able to add anything to a Roth IRA that year. To get the highest deduction for your adjusted gross income, you should put your entire investment in your traditional IRA.
The IRS offers these tax benefits on IRAs to help people save for retirement. You aren't supposed to take your money out until you turn 59 1/2. If you need to take money out early, you may need to pay income tax plus an extra 10 percent penalty on your withdrawal. For the traditional IRA, the tax and penalty apply to every dollar you take out, since it's funded with before-tax money. With the Roth IRA, you are allowed to withdraw your contributions out without owing anything to the IRS, because you've already paid taxes on this amount before you contributed it. However, if you take your investment earnings early, you'll owe income tax plus the penalty on their withdrawal.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.