Individual Retirement Account

An Individual Retirement Account, known as an IRA, is a personal account held under rules instituted by the Internal Revenue Service. There are several different types of IRAs including a traditional IRA, Roth IRA, SEP IRA, SIMPLE IRA, Self-Directed IRA, and the Coverdell Education Savings Account.

Contributions to IRA's may be tax deductible at specified income limits and capital gains taxes are deferred until the funds are withdrawn. To reduce taxes, it is advisable to invest in stocks in taxable accounts and bonds in tax deferred accounts.

There are several differences between a Regular IRA and a Roth IRA.

Regular IRA

Investment: 2,000 + 560 tax savings on tax-deductible IRA investment
Timeframe: 20 years
Rate of return: 12.2% tax-deferred IRA investment, 8.8% on investment tax savings
Funds available after 20 years: $20,000 pre-tax from IRA investment, $3,025 after-tax from tax savings
Funds available after 20 years assuming a 15% marginal tax rate at retirement: $20,025
Funds available after 20 years assuming a 28% marginal tax rate at retirement: $17,425
Funds available after 20 years assuming a 40% marginal tax rate at retirement: $15,025

Roth IRA

Investment: $2,000, no tax deduction
Timeframe: 20 years
Rate of return: 12.2% tax-deferred IRA investment
Funds available after 20 years: $20,000
Funds available after 20 years assuming a 15% marginal tax rate at retirement: $20,000
Funds available after 20 years assuming a 28% marginal tax rate at retirement: $20,000
Funds available after 20 years assuming a 40% marginal tax rate at retirement: $20,000

The advantage of a Roth IRA is that the benefit of tax-free withdrawals at the end game is greater than the initial tax deduction benefit of a regular IRA. The lone caveat is an investor would choose a regular IRA over a Roth if they expect their tax rate to be much greater at initiation compared with the withdrawal timeframe tax rate.

As of 2008, tax deductible contributions into a regular IRA is $5,000. Roth IRA contributions are not tax deductible. Funds can be withdrawn tax free if invested for at least five years and are held until the individual reaches the age of 59 ½.

Funds withdrawn from a regular IRA, Roth IRA, or 401(k) before the age of 59 ½ are hit with an additional 10% penalty on top of a normal marginal tax charge.

Financial Terms by BetterTrades