An IRA is a special type of account that comes in a few flavors, but for now, weâ€™re going to focus on the two most common: traditional and Roth.
The traditional IRA allows you to invest a certain amount of your income and deduct those contributions from your taxable income (you invest with pre-tax dollars). In an extremely simple example, if you make $50k per year and you invest $4k in an IRA, your taxable income is reduced by $4k, to $46k. However, there are a few catches:
- In general, the money canâ€™t be withdrawn without penalty until the account owner reaches 59.5 years of age. Thereâ€™s a list of exceptions, most of which are related to financial hardship and certainly not something you would want to plan for.
- You MUST start withdrawing the money at age 70.5.
- When you actually withdraw the money at retirement, the withdrawals are treated as normal income and taxed as such.
- For 2007, youâ€™re limited to $4000 in contributions per year if youâ€™re under age 50. This will increase to $5000 in 2008.
- If your household is covered by an employer-sponsored retirement plan, then there are income limits for the IRA, but theyâ€™re messy and complicated. Essentially, if you make less than $50,000, youâ€™re safe. More on this laterâ€¦
A Roth IRA is similar to the traditional IRA, but the taxation works in reverse: instead of not paying taxes on the initial contributions and paying taxes on the withdrawals when you retire, as with a traditional IRA, a Roth IRA allows you to pay taxes on your initial contributions and withdraw your earnings at retirement tax-free. There are several other advantages as well:
- Higher income limits: Single filers can contribute if you make less than $99k. Joint filers can make up to $156k. This is simplified, but thatâ€™s the general idea.
- There are no required withdrawals at age 70.5, as with the traditional IRA.
Which to choose?
This is a very complicated question that depends on future variables for the optimal answer, but in general, you should invest in a Roth IRA if you expect that you will be in a higher tax bracket at retirement than you are now. My personal opinion on the subject is that with the unfunded liabilities our government is currently incurring, theyâ€™ll have to raise taxes severely in the future to compensate. I like the peace of mind that the Roth IRA offers because I know that Iâ€™ve already paid my taxes on that money and anything I withdraw at retirement is mine to keep. This particular subject (traditional vs. Roth, both for IRAs and for 401kâ€™s) is worth delving into deeper in a future post.
What can you invest in with these accounts?
Pretty much anything, provided that the place where you open the account offers it. You can invest in stocks, bonds, mutual funds, index funds, hedge funds, money market funds, real estate, options, etc. Keep in mind that Iâ€™m not recommending most of these asset classes, especially when youâ€™re just starting out. But itâ€™s nice to know that you can choose the best investments for your situation, including down the road when your investing prowess has increased.