Tax Advantages of a "Traditional" IRA

With traditional IRA plans (we'll talk about Roth IRAs in just a moment), your contributions are at least partially tax deductible. (Find more information about IRA deductibility information here.) That means, the monies you contribute come right off the top of your adjusted gross income (AGI) on your tax returns, reducing the taxes you owe. That's a good way to beat the government at its own game ... but they'll get you later when you start withdrawing the money!

For 2008, you can contribute to your IRA and effectively erase $5,000 (or $6,000 if you're over 50) from your taxable income, just paying taxes on the remainder. Now, maybe $5,000 doesn't sound like much, but that can add up to an extra $1,120 in your pocket if you are in the 28% bracket – enough to help pay for a few extra gallons of gasoline or, even better, a few days in the Bahamas!

It's not quite "free money" from Uncle Sam, but it's about as close as you'll ever see (except for special, one-time tax rebates), so you really need to take advantage of his benefit.

Then, all of the earnings you accumulate and the deductible contributions you make are not taxed until you withdraw the money. This is the tax deferral advantage, which may be more significant than you realize. Since you may not be working in your retirement years, your tax bracket should be lower (we hope) than it is now. Consequently, your tax bite will also be less when you withdraw the money, probably considerably less (if Congress doesn't go and change things on us!).

Listen, you don't often find a way to legally reduce the increasingly onerous tax burden levied by the federal, state and city governments. But IRAs give you that very opportunity. And you get it for doing something that is incredibly good for you in the long run–socking money away for a bigger nest egg.

Avoid the Painful Penalties

Of course there is a downside. (Isn't there always?)

If you withdraw any of your money out of your IRA before you reach age 59-1/2, except under very special circumstances, you will be heavily penalized. It is taxed as income AND you will be assessed a 10% penalty on the amount you prematurely withdraw. Ouch. For obvious reasons, we recommend you avoid early withdrawals from your IRA unless absolutely necessary.

There are some instances where you can withdraw money and avoid the 10% penalty. These include non-reimbursed medical expenses, medical insurance premiums, the death of the IRA owner, permanent disability, to help pay for a first-time home purchase (with limits), higher education costs, and if the money will be used to pay back taxes to the IRS after a levy has been put on an IRA. Keep in mind, however, you will still owe the income taxes. (Learn more about withdrawals and penalties here.)

Next: Roth IRAs - The New Kid on the Block

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