Investing in an individual retirement account, an IRA, is an excellent way to jumpstart your retirement savings and build some security for your future.
There is no right or wrong age to look into building your retirement savings – though I will say, as you can imagine – the earlier, the better! With so many retirement accounts to choose from, finding a retirement vehicle that best suits you may seem daunting.
Let’s start by covering two of the most popular individual retirement accounts:
Traditional IRAs and Roth IRAs.
What is a Roth IRA?
A Roth IRA is an individual retirement account in which you put after-tax money into the account and your investments grow tax-free.
The key point of a Roth IRA is that your investments grow tax-free. Thus, when you retire and withdraw the money from your account, the money is withdrawn tax free.
This is because you already paid taxes on the money you put into savings.
What is a Traditional IRA?
A traditional IRA is similar to a Roth IRA – you’ll see the key difference between these two are how they are taxed.
Traditional IRAs are individual retirement accounts that take pre-tax money and investments grow tax-deferred until you withdraw after retirement.
Tax-deferred means that you won’t pay taxes until you withdraw the money from your traditional IRA.
These retirement accounts do have some things in common:
Traditional IRAS and Roth IRAS have contribution limits
Both a traditional IRA and Roth IRA have a contribution limit of up to $6,000 per year ($7,000 per year if you are older than 50).
They also are not investments themselves just accounts that hold your investments. For example, if I own $10,000 in Tesla stock, I can own it in either a traditional IRA or Roth IRA. It’s the tax treatment of each that matters here.
Both traditional IRAs and Roth IRAs are tax deferred in terms of the growth of your investments. Say I get quarterly capital gains, dividends, or interest income from my investments within my IRA, I don’t pay taxes unless I take it out.
Otherwise, it is reinvested within your investments to compound the growth. All of which is being held within your IRA account.
No age limits
There is no age limit for contributing to either a traditional IRA nor a Roth IRA. You can continue to contribute to a Roth or traditional IRA after you retire.
Key Tax Benefits
The main draw to a Roth IRA for most people is that, after you reach 59 and a half, you are permitted to take out any amount of your Roth IRA account and it is not considered taxable income! That’s because you contribute to a Roth IRA with after tax dollars.
Additionally, the same goes for five years after your first contribution. Then contributions can be withdrawn at any time, tax-free and penalty-free.
Yea. Pretty sweet.
With time and maxing out the contribution limits of the Roth IRA each year, you could be sitting on a potential retirement account that will allow you to live a fantastic retirement life without adding to your taxable income.
No RMD Requirement
With a traditional IRA, you have what is called required minimum distributions. This is how the IRS gets you to pay taxes. Because traditional IRAs are essentially offer a tax deduction upon contribution, the IRS taxes your traditional IRA when you’ve retired.
If you are wanting to not pay taxes from your retirement account, then comparing the Roth IRA vs the traditional IRA, Roth wins.
Traditional IRA contributions
Contributions to a traditional IRA are tax-deferred. Meaning, you pay federal income taxes when you withdraw money from your investment, instead of paying taxes up front.
So, you’ll pay taxes, but you will also get tax benefits – deductions – in the years you contribute.
Unlike the Roth IRA, contributions to a traditional IRA are tax-deductible in the year you make the contribution- on both state and federal tax returns.
Key Potential Downsides
Not everyone is eligible to contribute to a Roth.
Your income cannot exceed a certain amount in order to make the maximum contribution to your Roth IRA.
In some cases, you can make partial contributions. If you exceed the maximum earnings bracket, however, you are not eligible to contribute to a Roth.
As of 2022, the Roth IRA income phase out ranges for single taxpayers is $129,000 to $144,000.
Traditional IRAs have RMDs, required minimum distributions. After age 72, you are required to take out a minimum amount of money from your IRA – otherwise, you’ll face tax penalties.
If you withdraw money from a traditional IRA before you are 59½, you’ll pay taxes and a 10% early withdrawal penalty.
Distributions, or withdrawals, after you retire will be taxed as ordinary income.
Conclusion & Takeaways
There are pros and cons to each of these individual retirement accounts. You need to think about what your individual needs are and what type of IRA will benefit you the most.
Consider whether you fall in the lower tax bracket or the higher tax bracket. If you fall in the lower tax bracket, then a Roth IRA might be the best choice for you.
What kind of advantage is best for you? Would you rather have tax-free withdrawals in the future, or tax benefits now? If you’d rather have tax benefits year-to-year, then perhaps a traditional IRA is best for your needs.