What Is an IRA?
Before I answer this question, I’ll share another one that I’m asked frequently.
“What are IRAs paying?”
When someone asks me this question, I bite my tongue and think about candy bar wrappers, envelopes and garages.
I'm not kidding. I’ve found these analogies to be a helpful way to keep from uttering a snarky “nothing” in response to the inquiry.
Why nothing? Because contrary to what some people think, an IRA itself is not an investment. It’s really just a special type of account established by the government to encourage folks to save for retirement. It’s an account Uncle Sam makes more enticing by offering special tax treatment to those willing to commit for the long haul.
And since it’s an account and not an investment, an IRA really doesn’t pay anything. An IRA is a container — a candy bar wrapper, envelope or garage, if you will. The investment stuff inside of an IRA is what provides the interest or return.
Want growth potential from your IRA? Consider purchasing market-based investments like stock mutual funds or exchange traded funds. Want safety and security? Consider choosing something like a CD. You get to make the call.
The specific IRA you select will govern the tax treatment of the account, not the returns. Let’s look at two common IRA types.
Traditional IRAs have been around since the 1980s. They provide deferral of taxes on the investment income inside the account and in certain circumstances can lower your taxes when you contribute. Unfortunately though, not everyone can deduct their contribution to an IRA. Here’s a link to the IRS rules on the topic. 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.
Roth IRAs haven’t been around quite as long as their traditional sibling, but they also offer some significant tax advantages. As with a traditional IRA, Roth IRAs allow you to defer taxes on the interest, dividends and capital gains generated by the investments you choose. Again, 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, you cannot deduct your contributions. They go into the account on an after-tax basis. 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 Unlike a traditional IRA, Roth contributions can be withdrawn at any time without taxes or penalties — not so for earnings, though.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, including waiting until age 59 ½, 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 mentioned 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. Check out IRS Publication 590-A for the information you’ll need on these topics or check with a qualified tax professional.
Kate's note: It's not too late to open an Individual Retirement Arrangement account. You can open an IRA for 2016 until the April 2017 tax filing deadline. It's a great way to finish off your financial year!