Saving for retirement can be a daunting task. However, if you don't start thinking about how to fund your retirement, you can be left with an empty nest egg.
One of the great ways to save for retirement is to fund an individual retirement account (IRA). You can choose to invest in either a traditional IRA or a Roth IRA.
Know the differences
Before making a decision between these two options, it is important to understand the differences. The main difference can be boiled down to the following:
- Traditional IRA. Avoid paying taxes on contributions now; pay taxes later.
- Roth IRA. Pay taxes on contributions now; never have to pay taxes again.
This distinction is very important. Choosing the right option depends on your tax situation.
For example, if you expect to be in a lower tax bracket during retirement, it may be a good idea to contribute to a traditional IRA. Contributions made to a traditional IRA can reduce your tax burden, since they are usually tax deductible.
So by choosing to invest in a traditional IRA, you avoid paying higher taxes now, while hopefully paying lower taxes on the money when you withdraw it during retirement.
However, if you are paying a relatively low tax rate right now, a Roth IRA may make more sense. Sure, you will have to pay taxes on the contribution today. But once you have done so, you do not have to pay taxes on any gains you enjoy in the future.
Know the limits and penalties
For 2014, both the Roth IRA and traditional IRA allow a contribution of the smaller of your total taxable compensation or up to $5,500 (or $6,500 for individuals over the age of 50).
Your income will determine whether you are able to contribute to a Roth IRA. However, there are no income limitations for contributing to a traditional IRA as long as you are under the age of 70 1/2.
Also remember that if you withdraw the money early -- before the age of 59 1/2 -- you may pay penalties. Early withdrawal of money from a traditional IRA will trigger a tax bill, plus you will be subject to an additional penalty of 10 percent.
Early withdrawal from a Roth IRA is not taxable, since you already have paid taxes on that contribution. However, you may be subject to the 10 percent penalty.
There are exceptions that will allow you to withdraw money early and penalty-free from both a traditional IRA and a Roth IRA. To learn more, consult with your tax professional.
Kemberley Washington is a professor at Dillard University in New Orleans and certified public accountant. Follow her on Twitter at @kemwashcpa.