A retirement account can reduce your tax bill, but the type you decide to use determines when

vacation early retirementKokliang/ShutterstockTraditional and Roth IRAs have their advantages.Kokliang/Shutterstock

  • An IRA, or Individual Retirement Account, is a retirement savings account that can reduce your tax bill - now or in the future. 
  • If you invest in a Roth IRA, you'll pay taxes on the money you contribute today, but not when you make withdrawals during retirement. 
  • If you invest in a traditional IRA, you'll save money on taxes today but will pay taxes when you take out money during retirement. 
  • Both a traditional IRA and a Roth IRA have certain income limits and exclusions, so it's important to figure out which one is best for you. 

You have a lot of options when it comes to saving for retirement. 

Contributing to a 401(k) is a great starting point, especially if your employer offers a match. But if that's not an option, or if you want to save even more, you'll probably find yourself deciding between a traditional and a Roth IRA. 

Here's how to determine which one is better for you. 

What is an IRA?

An IRA, or Individual Retirement Account, is an important, tax-advantaged retirement account. You can find an IRA at most major brokerages and banks, including both online and brick-and-mortar financial institutions.

You can save up to $6,000 total in an IRA (either a Roth or a traditional) in 2019 if you're under 50 years old. If you're 50 or over, you can save a total of $7,000. This includes a catch-up contribution of $1,000. 

An IRA can save you money on taxes while also motivating you to save for retirement. However, the tax treatment of traditional vs. Roth IRAs is different. Before putting thousands of dollars into one of these accounts, you should review the tax implications and consider your expectations for the future to make sure your money goes the right place.

How a traditional IRA works

A traditional IRA used to be the only kind of IRA. Generally, contributions are made on a pre-tax basis, meaning you won't pay taxes today on the amount you save. It's similar to how most 401(k) contributions work.

Read more: There are 2 primary types of retirement savings accounts - and people don't realize you can use both

 To better understand what that means, let's look at an example. Let's say you make $60,000 per year and contribute $6,000 this year to a traditional IRA. That means your taxable income will be reduced by $6,000, so you'll only pay income taxes on $54,000. 

For a single filer, that would shave about $1,320 off of your tax bill. For a married couple filing a joint tax return, a $6,000 IRA contribution lowers their tax bill by about $720. 

In some cases, a traditional IRA contribution is not deductible. If you have access to a retirement plan at work, you have to make $64,000 or less to deduct a traditional IRA contribution. If you don't have access to an employer's retirement plan (and your spouse doesn't either), you can deduct your contribution regardless of your income

Read more: How automated saving and investing really works - and why more of us should be doing it

If your contributions to a traditional IRA are tax-free, you will have to pay taxes on withdrawals in the future. That means a traditional IRA is typically best for someone who expects to pay a lower tax rate in the future or who has a shorter time frame for their investments to grow before they begin to withdraw. 

How a Roth IRA works

Contributions to a Roth IRA are not tax deductible today. This means you do pay taxes on contributions you make this year. But in exchange, you don't pay taxes on withdrawals in the future. If you are a younger investor with decades for your investments to grow before retirement, a Roth IRA is a great option.

Roth IRA accounts have the same contribution limits as traditional IRA accounts: $6,000 for 2019 (or $7,000 if you are 50 or older).

Income limits do apply for Roth contributions, however. To make the maximum contribution in 2019, a single taxpayer has to earn less than $122,000 and a married couple filing jointly has to earn less than $193,000. 

Traditional vs. Roth IRA

There are a few factors to consider when choosing between a traditional and a Roth IRA: 
  • Your current income (and eligibility) for each account
  • Whether you expect your tax rate to be higher today or in the future (the higher your tax rate is now relative to what you expect it to be in the future, the more attractive a traditional IRA is)
  • The amount of time before you begin withdrawing from your account (the longer you have, the more attractive a Roth IRA is)

One of the best parts of an IRA - whether you choose a Roth or a traditional IRA - is that it is independent of your employer. You can open an IRA at your favorite brokerage and choose virtually any stock, bond, mutual fund, ETF, or other eligible investment for your account, which offers more control over your portfolio and the fees you pay. 

Disclosure: Axel Springer is Business Insider's parent company.

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