To help Americans save for retirement, the Internal Revenue Service created a number of tax benefits for the individual retirement account. When you contribute money to an IRA, it will have an impact on your taxes in a few different ways. The exact impact depends on what type of IRA you contribute to, the amount you contribute and when you take your money out.
When you invest in a traditional IRA, your entire contribution is tax-deductible. This means your investment will give you a break on your taxes while also putting money aside for retirement. As of 2012, you can invest up to $5,000 a year into your IRA. If you are 50 or older, you can invest up to $6,000. If you max out your IRA investment for the year, you'll get a tax deduction equal to these amounts, provided your adjusted gross income is within certain IRS-established limits.
If you invest in a Roth IRA, your contributions are not tax-deductible. The Roth IRA must be funded with after-tax dollars. This account doesn't give a tax deduction because it pushes your tax benefit until retirement. If you keep your money in your Roth IRA until you turn 59 1/2, your withdrawals are completely tax-free. When you take money out of a traditional IRA, the entire withdrawal is taxable.
Putting money in an IRA also changes the tax impact on your investments. When you keep your investments in a regular brokerage account, you owe income tax on your gains right away, even if you reinvest the earnings. When you invest in a traditional IRA, you don't owe tax on your earnings as long as they stay in the account. This gives your money more time to grow and creates a larger nest egg in retirement. The Roth IRA is even better. If you keep your investments in your account until retirement, you never owe tax on the investment income.
There is a tradeoff for investing in an IRA. These accounts are designed to be retirement plans. You aren't supposed to take your money out until you turn 59 1/2. If you take your money out before, you've made an early withdrawal. When you make an early withdrawal from a traditional IRA, the entire amount is taxable. You'll also owe an additional 10 percent withdrawal penalty. The Roth IRA lets you take out your contributions early tax-free. However, if you take out your investment gains you'll owe income tax plus the 10 percent penalty on the withdrawal. Note that certain hardship exceptions may apply to early withdrawals in specific circumstances.
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