Individual retirement accounts (IRAs) may be just the vehicle to help you save for retirement. There are two main types of IRAs: Traditional and Roth. Each type offers very attractive tax benefits, but the way taxes are handled on each is different. You and your financial advisor can determine which type is best for your situation.  

Tradional IRA

You may already be familiar with popular workplace retirement plans like 403(b)s and 401(k)s. In these plans, contributions are made before taxes are taken out. That money, and any potential earnings, are allowed to build over time. You don’t have to pay taxes until you take the money out—usually upon retirement.

From a tax standpoint, Traditional IRAs work the same way: taxes on earnings are deferred until you take the money out. Depending on whether you are covered by a retirement plan at work and what your modified adjustable gross income (MAGI) is, you may also be able to defer the taxes on your contributions, which would lower your current income taxes.

Roth IRA

Taxes on Roth IRAs work backwards from traditional IRAs in that you pay taxes up front: Your contributions are made after tax. The tax benefit comes later. Since you’ve already paid income taxes when the money went in, you won’t owe any tax on either the contributions or any potential earnings growth (capital gains, dividends, etc.).

Contribution and Income Limits

Both Traditional and Roth IRAs have limits on how much you can contribute each year. In 2010, the maximum contribution to either IRA (or a combination of both) is $5,000. If you are age 50 or older, you may be able to make an additional $1,000 catch-up contribution. These limits are subject to change in future years.

In addition, contributing to a Roth IRA is limited if your MAGI exceeds $105,000 (for singles) or $166,000 (married, filing jointly). If your MAGI exceeds $120,000 (single) or $176,000 (married, filing jointly), you won’t be able to contribute.

Early Withdrawal Penalties

The tax benefits for IRAs were established to help people save for retirement. For this reason, you may get hit with a 10% additional federal tax penalty for withdrawing money from a Traditional IRA prior to age 59 ½. You would also owe income taxes.

With Roth IRAs, you can withdraw your contributions penalty free at any time because you have already paid taxes. But any capital gains, dividends, interest, etc. is subject to taxes and a 10% federal tax penalty if withdrawn prior to age 59 ½.

Note that there are other details and rules governing these two valuable retirement opportunities. Ask your financial advisor for additional information.