Individual retirement accounts were introduced by the U.S. government in 1974 to encourage people to save for retirement. IRAs come with certain tax advantages to encourage you to save, as well as some restrictions. By contributing to your IRA regularly, you can save thousands of dollars in taxes and ensure your long-term financial security.
Knowing the basics of IRAs and how they fit into retirement planning can help you make smart financial decisions. Here’s what you need to know about IRAs and why you should max out your contributions.
IRAs and Taxes
Traditional and Roth IRAs are the two most common types of IRAs. The main difference between traditional and Roth IRAs is when you pay taxes on the money you contribute.
You can deduct contributions to your traditional IRA from your taxable income; you only pay income taxes once you withdraw the money. If you haven’t yet contributed the limit, you might want to add money to a traditional IRA before April 15 in order to reduce your tax liability.
Roth IRA contributions, on the other hand, come from after-tax dollars. You pay taxes on this income now, and won’t need to pay income taxes once you withdraw from your Roth IRA.
If you contribute to your IRA, you might qualify for the saver’s tax credit, although this depends on your income level.
Saver’s Tax Credit and 9 Other: Tax Loopholes That Could Save You Thousands
You must be under 70.5 years old to open or contribute to a traditional IRA; Roth IRAs have no age limit, however.
To contribute to a Roth IRA, your adjusted gross income must fall below a certain amount. This limit is $199,000 per year for those filing jointly and $135,000 a year for single taxpayers.
IRA Contribution Limits
The amount you are allowed to contribute to your IRA each year is limited. If you are under 50, you can contribute no more than $5,500 a year to all your IRAs. Once you reach 50, the annual limit rises to $6,500.
Contributions to Roth IRAs are further limited for single taxpayers earning over $120,000 a year and $189,000 for people who are married filing jointly.
Withdrawing Money From an IRA
There are restrictions on withdrawals from traditional IRAs; after all, the purpose of an IRA is to get you to save for retirement.
If you take money out of your IRA before you turn 59.5, you could get hit with an extra 10 percent penalty tax on the withdrawal. But there are exceptions. For example, you can withdraw money from your IRA without penalty for:
- Medical expenses
- College education expenses
- Up to $10,000 to buy your first home
Learn More: 17 IRA Withdrawal Rules You Need to Know
If you withdraw money from a traditional IRA after you turn 59.5, you won’t be hit with a 10 percent penalty tax. But the money you withdraw will be treated as taxable income; remember, you didn’t pay taxes on these contributions when you earned it, and Uncle Sam wants his cut.
If you want to withdraw money from your Roth IRA before you hit retirement age, you can withdraw your contributions at any time. There are limits, however, to when you can withdraw your earnings. Click to learn about Roth IRA withdrawal rules.
Once you turn 70.5 years old, you’ll need to start taking required minimum distributions from your traditional IRA. This rule does not apply to Roth IRAs while the owner is still alive.
Planning for Retirement With an IRA
Ideally, your IRA will be an important part of your retirement planning, which might also include an employer-sponsored retirement account such as a 401k and Social Security income.
To maximize your retirement savings, make the maximum contribution to your IRA each year. You also might want to talk to a financial planner to make sure you choose the right plan.
Choosing whether to use a traditional IRA or a Roth IRA depends on what you anticipate your future financial situation will be like. If you expect your tax rate to go up once you retire, you can pay the taxes now and contribute to a Roth IRA. If you think you will end up in a lower tax bracket once you retire, you will probably want to go with the traditional IRA. If you qualify for a Roth IRA, you can open both types of accounts and split your contributions between them.