IRAs, or individual retirement accounts, are bank accounts that are designed to help people save for their livelihood after they retire. IRAs can be offered through traditional jobs, however, the most popular IRAs are structured for individuals to use on their own. They are known as traditional and Roth IRAs. People like IRAs because they’re tax-advantaged. Contributions to a traditional IRA are tax-deductible, and the earnings grow tax-free. The reason for these perks is that these vehicles are designed for long-term investments.
The first IRAs were devised in the 1970s, and the Roth emerged in the late 1990s. A traditional IRA allows people to make withdrawals that are tax-free at the time, while tax is assessed later. A Roth IRA allows investors to pay tax now, and make tax-free withdrawals in the future.
As tax-advantaged investment instruments, traditional IRAs come with restrictions. They were devised to be something like a self-funded pension. Because of this, there are limits to how much and how often funds can be withdrawn. There’s also a limit on how much can be put into an IRA annually. For 2020, only $6,000 can be invested. There’s a higher contribution limit of $7,000 for people who are already over 60.
Roth IRAs are a little bit different. There aren’t as many rules surrounding these instruments. One of the biggest restrictions on Roth IRAs is about income maximums. In 2020, an individual must have a modified adjusted gross income of less than $139,000 in order to open or contribute to a Roth IRA.
The reason for these restrictions is the tax advantages that come with the IRA. They’re designed to help average Americans save for retirement, not so that the wealthy can avoid paying taxes. With a traditional IRA, the contribution someone makes reduces their tax liability for the year. For a Roth IRA, this isn’t the case but they save on paying tax in the future.
Roth IRAs are a good idea for people who expect to have high income well into their retirement. The opposite is true of traditional IRAs. They’re the best choice for people who expect a reduction in income during their golden years. Generally speaking, there’s an IRA that can be appropriate for everyone. The Roth and traditional IRAs are essentially opposites. Between them, one or the other will be a good fit for most Americans.