An IRA is an account you put money into that receives favorable tax treatment. Each year you can elect to contribute money to your IRA using “out of pocket” money, as opposed to your 401(k) contributions which must be funded through payroll deductions. The annual contribution limit is $6,000 in 2019 (or $7,000 for people who are 50 years or older), but be aware that if your income is high, you may not be allowed to contribute that much or anything at all.
In most cases, you need to open your own IRA. Much like it’s name – “individual” in “IRA” truly means individual!
IRA plans vary, but the two main ones are:
- Traditional IRAs, which reduce your taxable income if you are under a certain income limit. Since you contribute to an IRA with money that has been taxed already, you claim a deduction at the end of the year if you qualify. After you get your refund for your traditional IRA contribution this money becomes “tax-deferred” – you will pay income tax on your contributions and your earnings at your marginal tax rate when you take distributions from your traditional IRA in the future.
- If you contribute to a Roth IRA, your contributions have already been taxed at your current marginal income tax rate. In exchange, earnings may be distributed tax free if the distribution meets certain age and eligibility requirements.
Which one do you choose? It depends on a lot of factors, but the big ones are:
- Income – Qualifying high earners are usually better off contributing to a traditional IRA, as this allows them to avoid paying their current high marginal tax rate. Conversely, those with lower incomes usually favor the Roth IRA, as they can pay a low marginal tax rate now in exchange for never being taxed on that money again.
- Your guess about your future income tax rates – Those that believe they will be in a lower income tax bracket when they retire usually favor the traditional IRA if they qualify for the deduction. Those that believe they will be in a higher income tax bracket when they retire usually favor the Roth IRA. Those that believe income tax rates will rise across the board in the future usually favor Roth IRAs.
Money you contribute to your IRA must then be invested in the funds your IRA provider offers you.
