Welcome to Get Smart about Investing. Understanding the different types of IRAs can be difficult. In general, there are two types of IRAs: traditional IRAs and Roth IRAs. Each provide different tax benefits. With a traditional IRA, you get a tax deduction today for the money you contribute. Similar to company retirement accounts, the money is invested and grows, but you do not pay taxes each year. The only time you will pay taxes on the money is when you take it out, usually when you retire. Of course the government doesn’t want you getting too many tax benefits, so it is possible that if you have a company retirement account through your employer and your income is above certain levels, the immediate tax deduction would not be available. You could still make a contribution and get the tax-deferred growth, but not the bigger up-front deduction. Check with your financial company or tax professional to see if these limits would apply for your situation.
A Roth IRA works a little differently. With a Roth IRA, you contribute money but get no tax deduction today, though the money that grows each year is also tax-deferred. The big difference with a Roth is that when you take money out at retirement age, all of the money and gains come out tax-free. If you invested $4,000 into a Roth IRA and the money grew to $20,000, you would not have to pay any tax on the $20,000. Keep in mind that if your income is above certain thresholds, you may not be eligible to contribute money to a Roth IRA. That’s another aspect to look into. So again, the big difference between the two types of IRAs is, with a traditional IRA, you get a tax deduction today and pay all of the taxes on the money later. With a Roth IRA, you get no tax deduction today, but all of the money and growth comes out tax-free later.
I’m Greg McGraime and Now You Know!