Individual Retirement Accounts (IRAs) allow individuals the option to make contributions toward retirement accounts and invest with distinct tax advantages. IRA contributions are one of the few tax related deductions that you can claim even if it takes place after the end of the tax year (but prior to the tax filing deadline for the year). There are a couple of variations of IRAs that each have unique tax implications as well as contribution limits. The max contribution for 2013 to a IRA is $5,500 (or $6,500 if 50 or older). When most people refer to IRAs they are referring to traditional IRAs. We will start there.
Traditional IRAs typically have contributions made with pre-tax money, grow tax-free, and are taxed when money is distributed upon retirement. If an individual takes out money early (prior to age 59 1/2) from a traditional IRA then that money is subject to ordinary income tax rates and also typically subject to an additional 10% early distribution tax. If you are not taking an early distribution then the income is still subject to ordinary income tax but not a penalty. There are limits on the tax deductibility of traditional IRAs based upon your income, filing status, and whether an individual and/or spouse is covered by a retirement plan at work. It is best to talk through those details with a CPA.
The other factor with traditional IRAs is that they are subject to Required Minimum Distributions (RMDs) when the taxpayer reaches age 70 1/2. RMDs are one of the government’s way of forcing taxpayers to take money out of pre-tax retirement instead of passing it on to their heirs that way. The required minimum distributions typically depend upon the taxpayer's age and the amount of money in the traditional IRA. Again, it is wise to discuss with a CPA as you get within 5-10 years of that 70 1/2 age range.
Roth IRAs are different from traditional IRAs in that the contributions are made post-tax and the distributions (assuming not early distributions) are not subject to income tax. Roth contributions can be limited based upon income and filing status. It is best to talk through those specifics with a CPA.
There are tax advantages and disadvantages to both Traditional and Roth IRAs. In our view, there are advantages to have pools of money in both so that you have more flexibility when you reach retirement.