Estimated reading time: 2 minutes, 37 seconds
Choosing the right type of IRA for your individual situation is one of many decisions you must make among the bevy of decisions related to individual retirement investing. Unfortunately, many that begin the process of opening an individual retirement account are confused by the opposing terms “tax-deferred” and “tax-free.”
A common IRA myth is that some IRA structures are tax free. Worse yet, another myth is that IRAs are always tax free. Neither is the case.
A big misconception about a tax-deductible, tax-deferred IRA is that it will save you on taxes since you are contributing before taxable income. You may avoid taxes, but only temporarily.
“Tax deferral” means that taxes are deferred, or delayed, until a future date. In the sense of a Traditional, SEP or SIMPLE IRA, this specifically refers to funds added to a retirement account. As long as the account remains qualified under IRS rules, funds added to any of these accounts aren’t taxed until withdrawals begin. Thus, these types of IRAs are “pre-tax.” You will ultimately pay taxes on the contribution and any income generated in the account.
Some retirement investors like the idea that money otherwise spent on taxes remains invested, and that the invested amount can compound over the course of years—decades even. They may also believe that they will be in a lower tax bracket upon retirement age, which means that taxes charged at that later time might theoretically be lower than taxes charged immediately when funds are added to the account.
A big misconception about a Roth IRA is that it is tax free. “Tax-free” means that taxes are free upon retirement. Notice that it doesn’t mean that taxes are always free. With a Roth IRA, you are taxed immediately on contributions, but the account, including any income generated in the account, grows entirely tax free. Therefore, a Roth IRA is “post-tax.”
It’s often suggested that Roth IRAs are for those investors who know they will be in the same or a higher tax bracket upon retirement age and simply do not want to be taxed at that higher bracket—opting instead to be taxed upfront. Just know that you will have to pay taxes at one point or another.
Perhaps you can’t project what tax bracket you will be in upon retirement and, therefore, can’t decide which type of account is right for you. If you fall into this category, you may want to contribute to both types of accounts in an effort to spread out your tax burden.
If you still struggle with the concepts of “tax-deferred” and “tax-free,” it may be best to think of IRAs in terms of “pre-tax” and “post-tax.” But tax considerations should be just one area of concern when choosing an IRA type. Eligibility and age requirements are also important points to consider when choosing between the two types.
It’s always best to consult investing, accounting and tax professionals and discuss in detail what type of account, investment or strategy is best for you. When you’ve determined which IRA type is best for you, we would love to help walk you through the steps to open your Self-Directed IRA with Kingdom Trust.