When you've got a new career, student loans and decisions to make about whether to rent an apartment or buy a home, trying to decide whether a traditional IRA is right for you might be the last thing on your mind. Still, you know you're going to have to deal with it sooner or later. You might as well go ahead and weigh the pros and cons and get it over with.
Tax Deductible Contributions
If you're looking for a quick and easy way to cut your current income tax bill, a traditional IRA might just be the answer. Every dollar you contribute to a traditional IRA is tax-deductible, up to a maximum of $5,000 per year as of the 2012 tax year. If both you and your spouse each makes the maximum allowed contribution and you file a joint return, you can write off up to $10,000. If you are in a 28 percent tax bracket, that'll save you $2,800 in current income taxes.
Tax Deferred Growth
Investments held in your traditional IRA grow tax-deferred as long as they remain in the account. Since you don't have to pay taxes on the growth, you have more money to earn money. It's like compound interest on steroids. For example, a $10,000 CD paying 5 percent interest in a regular account would earn $500 in one year, but if you're in a 28 percent tax bracket you'd be left with only $360 after taxes. If that same $10,000 CD was in your traditional IRA, the entire $500 would be available to continue earning interest.
When it comes to traditional IRAs, the Internal Revenue Service has a "pay-me-now-or-pay-me-later" attitude. You get a tax deduction when you make your contributions, and your investments grow tax-deferred, but all withdrawals are taxed as ordinary income at your tax rate as of that time. If you contributed when you were in a 15 percent tax bracket but take withdrawals when you are in a 35 percent tax bracket, you'll have to pay taxes at the higher rate.
Congress intended individual retirement accounts to be just that -- retirement accounts. That means your money is there for the long haul. As long as you don't start taking withdrawals until you reach retirement age, 59 1/2 years as of the 2012 tax year, there's no problem. If you decide to withdraw money before then, not only will you owe ordinary income tax on it, but the IRS will also hit you with an additional 10 percent early withdrawal penalty.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.