The federal government uses tax policy to encourage people to
. You can use those incentives to your advantage, but it is also important to understand that they typically come with strings attached.
Traditional and Roth IRAs have different tax advantages, and are subject to different limitations. Here are some of the key tax features of each type of account.
A traditional IRA carries two forms of tax advantage: There is an immediate tax deduction when you contribute money, and any investment earnings, including interest and gains, are not taxed for as long as they are in the account. However, there are limitations. You can only deduct contributions up to $5,500 per year (or $6,500 if you are age 50 or older) and there is a 10 percent penalty if you take money out of a traditional IRA before you are age 59 1/2.
Also, the amount you can deduct may be even more limited if you are a high earner or if you are covered by a retirement plan at work. Beyond those limitations, what can be easy to overlook about the initial tax advantages of traditional IRAs over Roth IRAs is that they are essentially temporary. When you eventually withdraw money from a traditional IRA, it is taxed as ordinary income, and you are required to begin withdrawing money from an IRA once you reach age 70 1/2.
So, a traditional IRA does not eliminate taxes on your contributions and your investment earnings, but it does put them off. The premise is that people are likely to be in a higher tax bracket in their peak earning years, so an IRA allows them to put off taxation until retirement, when their income will be more limited and thus place them in a lower tax bracket. However, given the uncertainty of changes in tax rates, that benefit is by no means certain.