To understand IRAs, it's helpful to think about candy bar wrappers, envelopes or even garages.
No really...I'm not kidding! I’ve found these analogies to be very helpful during countless conversations that began with a seemingly simple question: "What are your IRAs paying?" At the very least, these analogies are far more descriptive than the well-rehearsed deadpan response that typically rolls off my tongue: “Nothing.”
Why nothing? Because contrary to what a lot of people think, an IRA is not an investment. It’s really just a special type of account established by the government to encourage folks to save for retirement — an account that Uncle Sam made more enticing by offering up some special tax treatment to those willing to commit to the long haul.
And since it’s an account and not an investment, an IRA really doesn’t pay anything. This is why they’re akin to candy bar wrappers, envelopes or garages. You see, it's the investment stuff you hold inside of an IRA that provide the return. Want growth potential from your IRA? Purchase investments inside it like market-based mutual funds or stocks. Want safety and security? Choose something like CDs.
As a matter fact, next to the tax advantages, one of the most attractive features of IRAs are their investment flexibility. The investing world is truly your oyster. But take heed of another analogy a former colleague of mine is fond of sharing. He says that an IRA is like a car — you can put any kind of engine you want into it. A “safe” engine goes slow and an “aggressive” engine can go much faster, but can be more damaging if you crash.
Let’s look at two common IRA types.
Traditional IRAs are the ones that have been around since the 1980s. They provide deferral of taxes on the money that grows inside of them, and they also provide the potential to lower your taxes when you contribute. The trade-offs? First, you generally can't use traditional IRA money before age 59 1/2 without incurring penalties. And second, you'll eventually have to pay taxes when you pull the money out. If you're in a higher tax bracket when you contribute, than you'll be when you pull the money out, traditional IRAs can offer you some pretty big tax savings. Unfortunately though, not everyone can deduct their contribution to an IRA. Here’s a link to the IRS rules on the topic.
Roth IRAs haven’t been around quite as long as their traditional siblings, but they also offer some significant, albeit different, tax advantages for retirement savers. One major similarity is that Roth IRAs also allow you to defer taxes on your earnings. There is no tax bill for what happens inside the account from one year to the next. There are, however, some major differences. First, with a Roth IRA, you cannot get a tax break for your contributions, they go in after tax. There are also differences when you make withdrawals. Unlike a traditional IRA, Roth contributions can be withdrawn at any time without taxes or penalties (not so for earnings though) and if you clear a couple of hurdles, you may never have to pay taxes on any growth you experience over the life of your account.
Make sure you’re eligible
Finally, as I alluded to earlier, there are some eligibility restrictions for both traditional and Roth IRAs and some deductibility restrictions with traditional IRAs, so be sure you’re eligible before you contribute to either. IRS Publication 590 has all the information you’ll need for this, but it can sometimes also be wise to check with a CPA or other qualified income tax preparer first.
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