If you have earned income, chances are you qualify to contribute to an individual retirement account. The government allows you to sock away up to $5,500 per year in a tax-advantaged IRA as of 2013. The max increases to $6,500 if you are at least 50 years old. Depending on your situation, you may have a choice between a traditional IRA or a Roth IRA. There's no difference in the internal rate of return, regardless of which type of IRA you have.
Individual Retirement Account
An individual retirement account, regardless of whether it is a traditional or Roth account, is just that: an account. It is not an investment. You can think of your IRA as a cup and your investments as coffee. The cup holds the coffee, but it is not coffee. In the same way, your IRA is a container that holds your investments, but it is not an investment.
You can hold the same types of investments in a Roth IRA that you can hold in a traditional IRA. Those investments will perform identically regardless of whether you hold them in a traditional IRA, a Roth IRA or a regular brokerage account. For example, if you buy a certificate of deposit from your local credit union, it will pay the same interest rate regardless of which account it is held in.
You can typically take a tax deduction for contributions to a traditional IRA, but you can't deduct contributions to a Roth IRA. Since you have to make your Roth IRA contributions with after-tax dollars, you have to earn more money to put the same amount of money in the account. However, you are never double-taxed. With a deductible traditional IRA, you pay taxes only once, when you withdraw the money. With a Roth IRA, you pay taxes only on the money you put in and your qualified withdrawals are tax-free.
The IRS takes a pay-me-now-or-pay-me-later attitude with your IRA money. You get a tax deduction for contributions to your traditional IRA, but you'll have to pay taxes on all of your money when you take it out of your account. You don't get a tax deduction for contributing to a Roth IRA, but all of your qualified distributions are free from federal income taxes. Which type of account offers the best return on your investment depends on your tax rate over the years. Assuming your overall tax rate is the same when you withdraw the money as when you invest, you will pay the same amount in taxes whether you pay upfront with a Roth or at retirement with a traditional IRA.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.