Preparing for your retirement is a critical aspect of your future financial security. However, it is easy to become confused about the various types of retirement accounts, particularly IRA’s and Roth IRA’s.
“IRA” stands for Individual Retirement Account. Although the term “IRA” may refer to several different types of accounts, it most often refers to a traditional IRA which is funded with pre-tax dollars. The way these accounts are funded is one of the primary advantages of utilizing an IRA.
Example: Mary draws $100,000 a year salary from her employer.
However, Mary contributes $4,000 to her traditional IRA; therefore, she is only taxed for $96,000, her income after her contribution is subtracted.
However, a Roth IRA is not funded with pre-tax dollars. It is funded with after-tax dollars; therefore, in the above example, Mary would still be taxed on the full $100,000 if she contributed $4,000 to a Roth IRA.
For the year 2005, the maximum amount that can be contributed to an IRA or Roth IRA is $4,000, unless you are over the age of 50. This amount will remain the same until the year 2008, when it will increase to $5,000. However, if you are over the age of 50, you may contribute $4,500 in 2005, $5,000 in 2006 and 2007, and $6,000 in 2008 and 2009.
Both the traditional IRA and Roth IRA are compounded tax-free. Therefore, if your account grows at 5% per year, paying the taxes on the 5% growth will be deferred or eliminated. This was designed in this manner to give people an incentive to save for their retirement and allows growth to occur at an accelerated rate.
Although a traditional IRA appears to be more advantageous because they are funded with pre-tax dollars, there are also other considerations to be made. A traditional IRA is funded with pre-tax dollars, but that means withdrawals on the funds are taxed as regular income. Therefore, Mary, in the above example, may avoid paying $4,000 in taxes this year, but when she withdraws money from her IRA in retirement, she will pay taxes on the amount she removes. On the other hand, contributions may be removed from a Roth IRA at any time without penalty. However, the growth or return on the account may not be removed without penalty unless you are over the age of 59 ½ and the account has been in place for at least 5 years.
For these reasons, a Roth IRA is a better choice for individuals that expect to be in a higher tax bracket in retirement than they are currently in. If you are currently in a lower tax bracket, it may be worth it to pay the taxes now in order to avoid paying them when you are in retirement.
The penalties for early withdrawal are the same with both types of accounts: 10%. However, you will not be penalized for withdrawing the principal amount of a Roth IRA, only the growth on the account. You will also pay taxes on withdraws if they do not meet the criteria for an exception, unless you are making a qualified withdrawal from a Roth IRA.