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Alexander Lee:

We all know it's important to save for retirement. But what's the best way to do it? There are many retirement vehicles to choose from  - 401(k) and 403(b) plans, IRAs, health savings accounts, and others. They're all designed with tax advantages that offer incentives to save for the future. In this video, we're going to talk about IRAs, short for individual retirement accounts or individual retirement arrangements. There are several types of IRAs, but we're going to focus on traditional IRAs, what they are, how they work, and why you might choose one.

Another popular type of IRA is the Roth IRA. To learn about Roth IRAs, please watch our "What Is a Roth IRA?" video. There are several differences between traditional IRAs and Roth IRAs.

The main difference is how taxes are handled. With a traditional IRA, your retirement savings are tax deferred. This means you won't pay income tax on the money you add to your IRA now. Instead, you'll pay when you withdraw money from the IRA in retirement.

A Roth IRA works the opposite way. You fund the account with dollars you have already paid tax on, and the money grows tax free. When you withdraw it, you pay no income tax. Why does it matter when you pay your taxes?

Traditional IRAs may allow you to lower your current taxable income, possibly up to the full amount of your contribution. For 2023, the maximum contribution is $6,500 per year for anyone under 50, or $7,500 for those 50 and over. Reducing your taxable income can possibly put you in a lower tax bracket for the year. In other words, you could end up devoting a lower percentage of your earnings to taxes.

Once you put your money into a traditional IRA, you choose investments, typically stocks and bonds, which hopefully increase in value over time. In a regular investment account, you generally pay annual taxes on anything you earn from your investments, whether it's interest, dividends, or capital gains on any sales. But with an IRA, you're temporarily shielded from these taxes. You'll only pay income taxes when you withdraw money in retirement.

Of course, with these tax benefits, there are some limitations. First, you can't withdraw from your traditional IRA before you hit retirement age. If you take money prior to turning 59 and 1/2, it's taxed as part of your income for that year, plus you incur a 10% penalty. You also can't keep money in your traditional IRA forever.

As of 2023, when you turn 73, you're required to take a minimum distribution from the account. In 2033, you'll be able to wait until you're 75. And remember, once you do withdraw the money, it will be taxed as ordinary income. The good news, though, is that if your tax rate is lower in your retirement years, either because you find yourself in a lower tax bracket or because tax rates have decreased overall, you'll pay that lower rate.

So to recap, a traditional IRA allows you to save for retirement on a tax-deferred basis. You pay no income tax until you withdraw your money in retirement. There are limitations on how you can use a traditional IRA. You incur penalties if you withdraw money early, and you're required to take minimum distributions starting at 73.

A traditional IRA is a great way to save for retirement. But it's not right for everyone. Your financial advisor can help you determine if it makes sense for you.

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