A traditional individual retirement account might be just the right place for you to stash some of your hard-earned dollars. Depending on your income you can typically contribute up to $5,000 each year into your traditional IRA. The max goes up to $6,000 once you hit 50. You get to take a tax deduction for your contributions, and all of your investments grow tax-deferred as long as they remain in your IRA.
The IRS considers all of your income, including any capital gains you earn when you sell an asset, to be taxable income, unless federal law exempts that income from taxes. If you sell some stock for more than you paid for it, Uncle Sam wants his cut. One of the big benefits of a traditional IRA is tax-deferred growth of your investments. It doesn't matter what kind of growth the investments in your IRA produce; interest income, dividends and capital gains are all treated the same. As long as the money stays your traditional IRA, however, you don't pay taxes on any of the growth.
Your traditional IRA becomes qualified once you turn 59 1/2 years old. That's when you can start taking distributions from your IRA without incurring an early distribution penalty. Any money you take from your traditional IRA is taxed as ordinary income at your then-current tax rate, regardless of how that money was earned. Earnings from dividends, interest and capital gains are all treated the same as your original contributions when they are withdrawn. They are all taxed as ordinary income.
All of the money in your traditional IRA, including your contributions and any growth that occurred within your IRA, belongs to you. You can withdraw it any time you want. If you withdraw money from your traditional IRA before it becomes qualified -- typically once you turn age 59 1/2 -- you'll owe ordinary income taxes on that amount and a 10 percent tax penalty. The IRS will waive the early distribution penalty in certain cases -- if you become disabled, for example, or use the money to pay for a first home -- but you'll still owe ordinary income taxes.
If you withdraw funds from your IRA after you retire, your tax obligation should be lower, as you likely will be in a lower tax bracket than when you made contributions. If you happen to be in a higher tax bracket when you start taking distributions than when you made your contributions, you might still come out ahead because of the tax-deferred growth of your investments. You might not come out ahead, however, on any capital gains in your traditional IRA. Long-term capital gains in an ordinary account are typically taxed at the more advantageous long-term capital gains rate. Since all withdrawals from your traditional IRA are taxed as ordinary income, you might pay a higher tax rate on those gains.