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Have a question? Ask our Retirement expert.

Have questions? Email Send your question to jbarnash@smartasset.com

Ask Our Retirement Expert

Have a question? Ask our Retirement expert.

Have questions? Email Send your question to jbarnash@smartasset.com

The Benefits of an IRA

Saving for retirement should always be a top financial priority but it can be difficult to get started if you’re not sure what your options are. If you’re not able to participate in an employer-sponsored plan, like a 401(k) or 403(b), an individual retirement account or IRA may be the answer to your retirement quandaries. Here’s a breakdown of how each type of IRA works.

Find out now: How much do I need to save for retirement?

Benefits of Traditional IRAs

If you’re looking to score a tax deduction for your IRA contributions, you may want to go with a traditional IRA. This type of account is funded with pre-tax dollars and your earnings grow tax-deferred. Depending on your income, you may be able to deduct some or all of your contributions. For tax year 2016, you can chip in up to $5,500 to a traditional IRA or $6,500 if you’re over age 50.

At age 59 1/2, you can start taking withdrawals penalty-free but you will have to pay income tax on the money. You can take early distributions from a traditional IRA without penalty if you’re using the money to buy your first home, pay for higher education expenses or if you have qualifying medical expenses but you’ll have to report it as income. Once you reach age 70 1/2, you’ll have to start taking minimum distributions or face a substantial tax penalty.

Whether or not you can deduct your traditional IRA contributions depends on your income, filing status and whether or not you participate in your employer’s retirement plan. For tax year 2016, single filers and heads of household covered by a plan at work can deduct the full contribution amount if their adjusted gross income is $61,000 or less. The full deduction is available to married couples filing jointly with an AGI of $98,000 or less and a partial deduction is available to married couples filing separately whose AGI is less than $10,000.

Related Article: Get Started With Retirement Planning

If you’re not covered by an employer’s plan you can deduct the full amount of your contribution up to the contribution limit if you’re single, file head of household or you’re married filing jointly and your spouse isn’t covered at work. If you’re married and file jointly and one of you is covered by an employer’s plan, your ability to deduct your traditional IRA contributions is phased out if your AGI is more than $184,000.

If you’re concerned about reducing your tax liability now, then a traditional IRA makes sense. By taking the deduction, you can reduce your taxable income and potentially lower your tax bill. Depending on your income, you may also be able to claim the Retirement Saver’s Tax Credit for some additional savings.

Benefits of Roth IRAs

The Benefits of an IRA

Compared to traditional IRAs, Roth IRAs are fairly new but they’re a popular alternative for people who may want to defer some of their tax benefits. A Roth IRA is funded using after-tax dollars, which means you won’t qualify for a deduction but you won’t have to pay any additional taxes on qualified withdrawals. The contribution limits for Roth IRAs are the same as traditional IRAs.

Roth IRAs have some important advantages. Your earnings grow tax-free and you can take out your contributions at any time tax and penalty-free, regardless of age. Withdrawals of earnings are generally tax and penalty-free as long as you’re over age 59 1/2 and your account has been open for at least five years. There are exceptions if you’re taking out the money to buy your first-home or because of a disability or death.

Unlike a traditional IRA, you’re not required to start taking distributions once you reach 70 1/2. You can also continue making contributions past this age. There is a catch, however. Your ability to contribute to a Roth is based on your income. For 2016, you can not make any contributions as a single filer with an AGI of more than $132,000 and as a married couple filing jointly earning more than $194,000.

SEP and SIMPLE IRAs

The Benefits of an IRA

If you run a small business or you work as an independent contractor, it’s still possible to fund an IRA for retirement. With a SEP IRA, you can contribute the lesser of 25% of your compensation annually or up to $53,000 for your employees or yourself in 2016. In-service withdrawals are allowed with this type of account but you will have to pay taxes on the money, plus a 10% early withdrawal penalty if you’re under 59 1/2.

If you just work for yourself, a SIMPLE IRA lets you chip in up to $12,500 for 2015 and 2016. Workers who are 50 or older can put in an extra $3,000. Distributions from a SIMPLE IRA generally follow the same withdrawal rules as a traditional IRA, which means you’ll have to pay taxes plus a penalty on any money you take out before age 59 1/2. Withdrawals taken after age 59 1/2 are subject to income tax only and you’re also required to take minimum distributions once you hit age 70 1/2.

Related Article: What is a SEP IRA?

Finding the right type of IRA for your financial situation means doing a little homework beforehand but it can really pay off in terms of the tax savings. Running the numbers on the benefits of each plan can help you find the best fit so you get the most out of your retirement savings strategy.

Photo credit: ©iStock/RapidEye, ©iStock/Kritchanut, ©iStock/SteveLuker

Rebecca Lake Rebecca Lake has been writing about the nuts and bolts of personal finance for nearly a decade. She is an expert in investing, retirement and home buying topics. Her work has been featured on The Huffington Post, Business Insider, CBS News, U.S. News & World Report and Investopedia. As a homeschooling mom of two, she's always looking for ways to make the most of every dollar.
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