Perhaps the biggest single item you’ll save for is retirement. It takes a hefty amount of cash in order to make your golden years, well, golden. Many people have turned to their workplace retirement plan – such as a 401(k) – as the preferred vehicle for those savings. The problem is, a workplace plan may not be enough. Moreover, not everyone has access to a 401(k) or similar plan through their employer.
Luckily, there are ways to save more, and outside an employer’s plan.
The humble individual retirement account or IRA is a wonderful vehicle for retirement savers. The account has plenty of special features that make savings a breeze. However, not all IRAs are the same. And the main versions of the account – traditional or Roth – have several key differences that do matter when it comes to retirement.
How do you know which one is right for you? Read on to find out.
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The IRA Basics
In reality, there are actually seven different varieties of IRAs. But unless you’re a contractor or small business owner, the main choice comes down to two – the Roth and the traditional. Both account types have a lot in common. For starters, they are just vehicles for savings. You can open up these accounts at most banks, mutual fund companies or at an online brokerage platform. You can use them to invest in a variety of assets. Money deposited in each can be invested in cash/CDs, individual stocks, bonds, mutual funds and so on. Really the sky’s the limit.
The Roth and traditional IRAs also allow you to contribute the same amount each year. Currently, contribution limits for 2018 are set at $5,500 per person, per year. That number rises to $6,000 in 2019. For those individuals aged 50 or older, the government allows investors additional catch-up contributions. This bumps the annual limits up to $6,500 for 2018 and $7,000 for 2019. Additionally, investors have until April of the following year to make their contributions for the current year. So you have until April of 2019 to max out your IRA for 2018.
Perhaps the biggest benefit of both IRAs comes down to taxes. All trades, dividends and interest income that occurs within the account is outside Uncle Sam’s grasp. That changes once withdrawals are made and depends on the kind of IRA an investor owns.
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The elder statesmen of the IRA world, traditional IRAs were introduced back in 1974 through the Employee Retirement Income Security Act. The idea was to encourage individual people to save for retirement – as pensions were starting to be a thing of the past – by offering special tax benefits.
The beauty of a traditional IRA is that you can save on taxes today. Depending on your tax situation, investors may be able to deduct some or all of their contribution to a traditional IRA to reduce their current taxable liability. The deduction begins to phase out based on current income, tax filing status and the availability of a workplace retirement plan to you or your spouse.
However, the benefit of saving on taxes today does come with a catch; you’ll need to pay those taxes when you withdraw later on in retirement. Investments in traditional IRAs grow tax-deferred. However, when you start pulling cash from the account, Uncle Sam wants his cut, and as a result traditional IRA withdrawals are counted as ordinary income. Worst still is that if you withdraw any funds before age 59½, there is an additional 10% tax penalty on the account. And unfortunately, Uncle Sam won’t let you defer taxes forever. At age 70½, investors are forced to take required minimum distributions (RMDs) from these accounts and pay taxes on them.
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For investors willing to give up some of the tax benefits today for potentially greater savings down the road, the Roth IRA could be a better choice. Like the traditional, the Roth allows you to defer taxes over the long haul. The real benefit is that withdrawals from the Roth are tax-free as long as you wait until 59½ to start withdrawing money. This is a stark difference to the traditional IRA, in which withdrawals are taxed. This is big news for savers with decades’ worth of compounding time ahead of them.
The Roth is beneficial in another way as well. If you need to withdraw money early for some reason, any contribution amounts made to a Roth – minus any interest or capital gains – are able to be withdrawn tax-free.
The kicker is, not everyone can take advantage of the power of the tax-free Roth IRA. Eligibility to contribute to a Roth is based on your income and begins to phase out as you hit the top of certain brackets. Looking at your tax filing status and so-called modified adjusted gross income (MAGI) determines the phase out. This chart from Vanguard shows the limits on income when it comes to a Roth.
Now, if your income is above these limits, there is a way to essentially convert a Traditional IRA to a Roth. However, rules on conversions are vastly different than rules on contributions and must be done properly to get the most benefits from them. This is one instance where some hand holding is best.
The Bottom Line
As a whole, IRAs are great vehicles for investors. The real question comes down to whether or not you want to save on taxes today or later in retirement. That determining factor is the biggest decision on whether or not to choose a Roth or traditional IRA. Certainly, low current tax-rate investors will almost always win out with Roth over time. However, for those in the middle or towards the upper end of the pack, the best course of action may be splitting the difference and contributing some money to both if you are able.
All in all, the humble IRA account is a great addition to any savings, regardless of tax bracket.
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