An IRA, or individual retirement account, is a good option to consider if you're already maxing out your contributions to a workplace-sponsored retirement plan or if you're looking for additional ways to diversify your retirement savings.
IRAs come in two flavors: "traditional" and the Roth -- but key differences in how contributions are made, how withdrawals are taken and what time horizon funds will be invested over can change which plan might be best for you.
In both cases, maximum annual contributions of $5,500 can be made until a person hits age 50, after which contributions rise to $6,500, depending on your income and marital status.
, you pay taxes on contributions before they're placed in the account (called an aftertax contribution). This is one reason it can be an ideal investment option for younger savers. In a traditional IRA, you don't pay taxes on your contributions until you withdraw the money in your retirement years, after age 59½ (called a pretax contribution).
But assuming a younger person will start his or her career in a lower tax bracket than he or she will finish it, contributing to an aftertax Roth IRA earlier likely has a tax advantage. The flip side is true for an older saver, who'll presumably be in a higher tax bracket: Contributing to a traditional IRA and being able to deduct contributions from his or her current income taxes may make more sense.
"Most young adults have lower incomes in their early earning years than they do later in their careers and even retirement. By using a Roth IRA now, they can take advantage of being in a lower income tax bracket and potentially avoid higher tax rates when it comes time to start distributing funds from their retirement accounts," financial adviser Jared Parks told CBS MoneyWatch.
It's also a hedge against the possibility that income tax rates will be higher by the time a person is ready for retirement.
In general, it takes about 10 years for the Roth to make up for the initial upfront tax payments. So for those over 50, a traditional IRA may be a better consideration because you may be eligible to deduct contributions from your taxes.
Think of it this way: If you invest $5,500 in an Roth IRA per year beginning at age 30, assuming a 7 percent annual rate of return, you would have $241,000 by age 50. That's $130,000 in tax-free earnings.
If you invest $5,500 annually in a traditional IRA over the same time horizon, you're looking at an expected $205,000 after taxes -- $36,000 less.
Another advantage to the Roth: You can withdraw the initial contribution money you put into the account tax-free at any time. Keep in mind, however, that the money that accrues (earnings on your initial contributions) cannot be withdrawn without a 10 percent penalty before age 59½. In a traditional IRA, you're subject to pay taxes and early-withdrawal penalties on any funds (contributions or earnings) you take out of the account, unless you qualify for early distributions.
The Roth IRA can be also be helpful as a saving vehicle for those looking to purchase their first home. That's because in addition to being able to withdraw initial contributions tax-free and put them toward a down payment, first-time homebuyers can also take up to $10,000 of the earnings from their Roth and apply it to the down payment without any early-withdrawal penalties.
"With a traditional IRA, you would be limited to a maximum of $10,000 penalty-free, and the entire amount you withdraw would be taxable at their ordinary income rate," financial adviser Steve Wright wrote in an email to CBS Moneywatch.
That being said, it's best to be cautious when using the money from retirement funds to handle other financial matters because it will hurt the compounding interest that builds earnings in the account over time. Any decisions to withdraw funds early should be considered carefully based on your financial goals.
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