More and more Americans are investing in IRAs, or individual retirement accounts, to give their savings plans a big boost. If you don’t have a 401(k) retirement savings plan through your employer, consider an IRA. They offer somewhat similar benefits to traditional 401(k)s. For instance, just as with a 401(k), with an IRA, you don’t pay any taxes each year on capital gains, dividends and distributions.
But one big advantage of an IRA savings plan is the tax advantages that come with it. Before we get into the tax advantages of IRAs, however, it’s important to note that IRAs come in two main types – a Traditional IRA and a Roth IRA. Here’s a further look at these two savings plans and the tax benefits of each:
A Traditional IRA allows you to deduct up to everything you put into the IRA in a given year from your taxable income, which can be a huge boost to your tax return at the end of the year. The contributions you make may be tax-deductible, thus saving you money during the tax year the contribution is claimed. Putting money into a Traditional IRA allows for tax-deferred growth. You won’t owe taxes on it until you begin withdrawing it, usually after you retire and possibly are in a lower tax bracket.
Unlike with Traditional IRAs, the contributions you put into Roth IRAs are not tax deductible. However, the benefit comes as the contributions you make grow tax-free, and the qualified withdrawals are also tax-free. You don’t have to worry about paying taxes on the withdrawals – no matter what the tax rate may be.
One of the main benefits of a Roth IRA is to avoid higher taxes when looking at combined incomes during retirement, as Roth IRA distributions are not taxed when you pull money out at retirement. If you don’t think you will have much or nothing in a 401(k) or at all when you retire, you might want to pass on considering it.
For qualifying details of IRAs, please review the IRS publication, Individual Retirement Arrangements (IRAs).
You can contribute to both, but the total combined must not exceed the allowable amount. For tax year 2013, it’s $5,500, or $6,500 if you’re age 50 or older.
Can’t decide? With IRAs you have until tax day, April 15, 2014 to make a contribution for the tax year 2013. So if you need a last minute tax deduction, you may want to consider contributing to a Traditional IRA.