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What's an IRA? Traditional and Roth IRAs Are Different

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Definition: An Individual Retirement Account, or IRA, is a tax-advantaged retirement savings account. That means its an account that allows you to save money for retirement, and to gain some type of tax benefit by doing so.

When people talk about IRA's, they're normally referring to Traditional IRA's unless they specifically state otherwise.

A Traditional IRA allows you to defer the income, capital gains and dividend taxes until you withdraw the money in retirement. If you earn $80,000 and you put $5,000 in your Traditional IRA, you're taxed as if you only made $75,000. (For simplicity sake we're ignoring other deductions in this example.) The money grows tax-deferred while its invested. You pay the entire tax bill when you withdraw.

A Roth IRA, in contrast to a Traditional IRA, requires you to pay the income tax upfront. However, you never pay taxes again, not even on capital gains or dividends.

If you earn $80,000 and you put $5,000 in your Roth IRA, you're taxed on the entire $80,000, but you avoid paying any capital gains and dividend taxes when you withdraw.

You can start withdrawing money from an IRA at age 59 and 1/2. There are penalties of up to 10 percent if you withdraw early from a Traditional IRA. You can withdraw your initial contribution to a Roth IRA penalty-free (because, after all, you already paid taxes on that income). You will, however, pay penalties if you withdraw your interest earnings from your Roth IRA before you reach retirement age.

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