The federal government uses tax policy to encourage people to save money. You can use those incentives to your advantage, but it is also important to understand that they typically come with strings attached.
Traditional and Roth IRAs have different tax advantages, and are subject to different limitations. Here are some of the key tax features of each type of account.
A traditional IRA carries two forms of tax advantage: There is an immediate tax deduction when you contribute money, and any investment earnings, including interest and gains, are not taxed for as long as they are in the account. However, there are limitations. You can only deduct contributions up to $5,500 per year (or $6,500 if you are age 50 or older) and there is a 10 percent penalty if you take money out of a traditional IRA before you are age 59 1/2.
Also, the amount you can deduct may be even more limited if you are a high earner or if you are covered by a retirement plan at work. Beyond those limitations, what can be easy to overlook about the initial tax advantages of traditional IRAs over Roth IRAs is that they are essentially temporary. When you eventually withdraw money from a traditional IRA, it is taxed as ordinary income, and you are required to begin withdrawing money from an IRA once you reach age 70 1/2.
So, a traditional IRA does not eliminate taxes on your contributions and your investment earnings, but it does put them off. The premise is that people are likely to be in a higher tax bracket in their peak earning years, so an IRA allows them to put off taxation until retirement, when their income will be more limited and thus place them in a lower tax bracket. However, given the uncertainty of changes in tax rates, that benefit is by no means certain.
Unlike contributions to traditional IRAs, contributions to traditional IRAs are not tax deductible. However, distributions from Roth IRAs are not taxable, as long as you are at least 59 1/2 years old, and the IRA has been set up for at least five years.
So, while there is less tax benefit on the front end, a Roth IRA does allow you to avoid paying taxes on money earned within the account. Therefore, the younger you are, the greater the tax advantage of a Roth IRA, since you will have more time to accumulate investment earnings and thus benefit from avoiding taxes on those earnings.
Taxation can be a somewhat emotional issue. People often resent having to give back part of what they have earned, which is one reason why tax breaks have such a strong appeal. The key is to realize that there is generally some form of commitment required in order to take advantage of these breaks, and it is that long-term commitment that you have to weigh against the short-term tax benefit.
Though tax breaks are designed to encourage Americans to raise their savings rates, in the end those tax breaks are somewhat limited. Thus providing for a comfortable retirement should be your primary motivation to save, rather than tax avoidance.