When you first set out to invest, there's a big learning curve involved. Open a book, read a website or consult a broker, and you'll be buried in unfamiliar terminology and an alphabet soup of acronyms. It's almost as bad as listening to computer programmers talk shop. One of the first things to understand is your Individual Retirement Account, or IRA. It's important to bear in mind that it's not an investment in its own right.
There's a tendency to refer to an IRA as if it's a kind of investment. In truth, it's more of a wrapper or container that can be used to hold a variety of individual investments. Consider how stealth aircraft hide missiles inside their fuselage, where they're as invisible to radar as the aircraft itself. An IRA acts the same way, keeping your investment profits off the IRS' radar. Your IRA is referred to as a "tax-advantaged" retirement plan, and it can either be tax-free or tax-deferred depending whether it's a traditional or Roth IRA.
Tax-Deferred vs. Tax-Free
One of the major benefits of retirement plans such as IRAs is that all the growth in your investments is sheltered from taxation. That leaves more money in place to generate gains, and over time this "snowball" effect has a major impact on your retirement income. However, traditional and Roth IRAs are different in their tax status. You can deduct your contributions to a traditional IRA, making them before-tax dollars. The IRS defers taxing them until you take your retirement income, when you are presumably in a lower tax bracket. With a Roth IRA, you contribute after-tax dollars and get no deduction, but your retirement income is truly tax-free rather than tax-deferred.
Types of Investment
There are a wide variety of investments you can hold within your IRA. You can hold stocks or bonds, certificates of deposit or T-bills and similar money market products. You can also hold mutual funds or exchange-traded funds -- ETFs -- that mimic a wide selection of those same investments. When you first start investing and have a limited budget, these investment funds give you the advantage of professional money management and a large, diverse portfolio to reduce your investment risk. Over time, as your financial goals evolve, you can adjust the holdings in your IRA to reflect your changing needs.
Until your portfolio's too big to fit into the yearly contribution limits for an IRA, you have no reason to think about how your growth is taxed. You'd simply put everything into your IRA and let it all grow without taxation. Once you've passed that point, there's a little more strategy involved. Capital gains and dividend income are taxed at a substantially lower rate than interest and regular income. Over time, it makes sense to move your assets around so that your interest-bearing investments are held within the IRA, while investments earning lower-tax capital gains and dividends are outside its tax-sheltered environment.
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