Understanding Individual Retirement Accounts (IRAs)
An IRA, or Individual Retirement Account, is a tool the U.S. government uses to encourage Americans to save for retirement. Because saving rates have historically been low, these accounts offer tax advantages to incentivize saving. Think of an IRA as an "account shell" within which you can buy and sell stocks and funds.
IRA Basics
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Investment Choices: You are responsible for choosing what to invest in within the IRA.
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Tax Benefits: Unlike a general stock market account, IRAs offer tax benefits that are not available in taxable brokerage accounts.
IRA vs. 401(k)
The 401(k) is a retirement account opened by your employer, where a portion of your salary is invested in stocks and funds for retirement. The IRA, in contrast, is opened by you, independently of your employer, at a financial institution. You can have both an IRA and a 401(k) simultaneously.
Opening an IRA
Many financial institutions, including American banks, Fidelity, and Robinhood, allow you to open an IRA. The process is typically simple and can often be completed online in a few minutes by answering some basic questions.
Types of IRAs: Traditional vs. Roth
There are two main types of IRAs: Traditional and Roth, each with distinct tax implications.
Traditional IRA
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Tax Deduction Now: Contributions to a traditional IRA can reduce your taxable income in the current year. For example, if you earn $10,000 and contribute $7,000 to a traditional IRA, you'll only be taxed on $3,000.
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Tax-Deferred Growth: You don't pay taxes on investment gains within the account until you withdraw the money in retirement.
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Taxable Withdrawals: When you withdraw money from a traditional IRA in retirement, the withdrawals are taxed as ordinary income.
Roth IRA
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No Upfront Tax Deduction: Contributions to a Roth IRA are not tax-deductible; you pay taxes on the money before it goes into the account.
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Tax-Free Growth: Like the Traditional IRA, your money grows tax-free within the account.
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Tax-Free Withdrawals: Qualified withdrawals in retirement are completely tax-free. This means you won't pay any taxes on the money you withdraw.
Key Differences Summarized
Both Traditional and Roth IRAs shield your investments from taxes while they're growing. The main difference lies in when you pay taxes:
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Traditional IRA: Pay taxes later, during retirement withdrawals.
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Roth IRA: Pay taxes now, but withdrawals in retirement are tax-free.
Which IRA is Right for You?
The better choice depends on your current and future income situation:
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High Income Now, Lower Income Later: A Traditional IRA might be more suitable, allowing you to reduce your current income tax burden.
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Low Income Now, Higher Income Later: A Roth IRA may be more advantageous, as you'll avoid paying taxes on potentially larger withdrawals in the future.
In both types of IRA accounts, you don't need to worry about paying tax during the process of investment. You will only need to consider the tax problems when you withdraw money.