Like HowStuffWorks on Facebook!

How IRA Tax Deductions Work

        Money | Taxes

What's an IRA?

It would probably be difficult to take full advantage of IRA tax deductions without first understanding what an IRA is. This investment tool allows people to squirrel away some of the money they earn for retirement. It also lets savers put that money to work in a wide variety of investments, from stocks and bonds to mutual funds. The account is managed by a financial institution, which allocates the money as directed by the investor. Because an IRA is a designated retirement account, investors are penalized if they take money out of the account before reaching a certain retirement age (currently: 59.5 years old) [sources: Fidelity, CNN, CNN].

There are three types of IRAs. A traditional account is one in which some or all of the money placed in the account isn't taxed until it's withdrawn, depending on the person's income and eligibility for tax deductions. This option is attractive to investors who want to reduce their current tax obligation and put off paying an excise on the funds until their non-working years, when their income — and tax bracket — is likely to be lower. Traditional account holders must start withdrawing from the IRA once they reach 70.5 years of age [sources: Fidelity, CNN].

A Roth IRA, on the other hand, is one in which the money allotted to the account is taxed right away. This money is treated as income for tax purposes and is used in determining an individual or couple's tax bracket. Some investors prefer this type of account because it allows the money to grow tax-free and gives them the luxury of taking that cash out when they need it (provided that they've reached the retirement age) without paying taxes on the funds. Unlike traditional IRA investors, people who put their money in a Roth IRA aren't required to start taking out some of the cash out at a certain age [sources: Fidelity, CNN].

A rollover IRA is a third type of retirement account that's used to invest money "rolled over" from an employer-sponsored account like a 401(k) or 403(b), an annuity offered to some public employees. These accounts are subject to the same rules and requirements as a traditional IRA [source: Fidelity]


More to Explore