Many people use IRAs to save money for retirement. Unfortunately, a lot of people don’t completely understand how taxes are levied on IRAs. It’s important to choose the type of IRA that coincides with the level of taxes you believe you’ll be paying in retirement. This applies to 401(k)s as well, because the 401(k) could be either a traditional IRA or a Roth IRA.
Contributions to a traditional IRA are not tax deductions, they are tax deferrals. This means that you will not pay the tax that is owed on the money now. Instead, your money will grow tax deferred and you’ll pay tax on the entire amount when you take it out. If you want or need to use your money prior to age 59.5, you’ll be charged a 10% penalty. If you believe that you are going to be paying less tax when you retire, the traditional IRA might make sense to use.
Contributions to a Roth IRA are made with after-tax dollars. This means that you pay taxes before you contribute to it. The nice feature of the Roth IRA is that all of the growth is tax free. However, there are income rules that prohibit the use of a Roth IRAs for people with income over certain thresholds. If you want or need to use it prior to age 59.5, you’ll be charged a 10% penalty. If you believe taxes will be higher in the future, the Roth IRA might make sense to use.
Private Retirement Plan
There is a third option that is similar to a Roth IRA, is privately owned (not controlled by the government), has far less income restrictions and allows access to your money without a penalty at any age. This plan allows you to store nearly as much money in it as you want and the best feature is that you can withdraw your cash (including all the growth / capital gains) tax exempt.
Additionally, cashflow from this account will not increase the tax on your Social Security. Money withdrawn from qualified plans (401(k), 403(b), IRAs) can add an additional 85% tax to your Social Security and double your Medicare premiums.