Two types of tax breaks are associated with two types of individual retirement accounts, or IRAs. One is a tax deduction in the year the contribution is made, and it is associated with a traditional IRA. The other is a tax break on earnings; it is associated with a Roth IRA. It is possible to partially combine both features by starting out with a traditional IRA and later converting to a Roth IRA.
In a traditional IRA, every dollar you contribute is subtracted from your income before taxes are computed. The result is a lower tax liability than you would have had without the IRA contribution. Earnings grow tax-free in the account. When you withdraw them, they are taxed at ordinary income tax rates. The thinking is that when you are earning the most you get a tax break, and when you withdraw the money in retirement your tax rate will be lower.
Withdrawals made before age 59 1/2 are penalized an additional 10 percent in addition to taxes. Minimum withdrawals are based on your life expectancy and must be made annually starting no later than age 70 1/2.
Single people who are covered by a retirement program through their jobs may contribute a maximum of $5,000 a year to an IRA ($6,000 for taxpayers 50 and older). The maximum is $10,000 for married couples filing jointly ($12,000 if each spouse is at least 50). To be able to make the maximum contribution, income must not exceed $56,000 for singles and $90,000 for married couples, as of 2011.
The value of your tax break on a traditional IRA is based on how much you have contributed and your tax bracket in the year of contribution. The more you contribute and the higher your bracket, the greater the tax break. For example, if you contribute $5,000 to an IRA, your taxable income is reduced by $5,000 whether you earn $20,000 or $55,000 a year. However, because a person who earns $50,000 is in a higher tax bracket than a person who earns $20,000, the contribution saves more for the person making $50,000, all other deductions and exemptions being equal.
In a Roth IRA you do not get a tax break on the contribution. However, the earnings grow tax-free, and they are not taxed when you withdraw the earnings or the original contribution. Depending on how long you have the account and how much you earn, the tax savings of a Roth can be more significant than those associated with a traditional IRA. Withdrawals made before age 59 1/2 are penalized 10 percent unless they are made for certain allowed reasons. There are no mandatory-withdrawal rules on Roths. You are allowed to open a traditional IRA and later convert it to a Roth IRA.
Mary Gallagher runs Mary Gallagher Planning (mgaplanning.com), an urban planning and consulting business in San Francisco. She is the former assistant planning director for San Francisco and planning director for San Mateo. Gallagher has been writing about real estate, development and land use for numerous websites since 1995. She holds a master's degree in historic preservation planning from Cornell University.