56% of Americans feel behind on saving for retirement, yet 25% of workers haven’t made retirement contributions in at least a year, according to Bankrate. For some, retirement is right around the corner, so much so that it can feel more scary than exciting. For others, it’s tempting to sweep saving plans under the rug since that time seems so far away. Regardless of your position, today’s actions build the savings for your future, and it’s never too late to start. But where DO you start?
Let me introduce you to my little friend: an Individual Retirement Account (IRA)
What is an IRA?
Specifically designed for retirement savings, IRAs are individual retirement accounts with tax advantages. Two of the most popular retirement accounts are traditional IRAs and Roth IRAs, and you can invest in both simultaneously. Today, we’ll discuss the pros and cons of each and how they can help you achieve your retirement saving goals.
For those of you with a 401(k), which is an employer retirement account, don’t worry. You can use both retirement accounts simultaneously and roll money from a 401(k) to an IRA. However, you may face tax deduction limitations (we’ll discuss that later). Additionally, you can transfer funds from your traditional IRA or employer retirement account to a Roth IRA.
Savings Accounts vs. IRAs
Before we jump into the details, you may think, “Can’t I just use my savings account to save for retirement?” These accounts keep your money safe but are not the best for growing or investing. It’s important to remember that savings accounts depend on interest rates for monetary growth. As a result, it’s unlikely that you will make a substantial profit with a 0.5% interest rate or something around that range.
While IRAs do not earn interest, you can use these accounts to invest in stocks, bonds, mutual funds, annuities, exchange-traded funds, and more. Consequentially, they usually have a higher rate of return (typically around 7-10%) than savings accounts and can make you more money.
Additionally, savings accounts are taxable. Therefore, the government can tax profits you’ve made from interest (earned interest), considering it earned income. In contrast, earnings grow tax-free within traditional and Roth IRAs through investments.
What is a Traditional IRA?
People may refer to traditional IRA as “tax deferred.” That is because you are taxed ordinary income tax when you pull money out of the account after the withdrawal age of 59 1/2. While you are not paying taxes initially on each contribution, you’ll be taxed later when you decide to withdraw those funds. Those taxes depend on whatever tax bracket you are in during retirement, otherwise known as your current tax rate. Therefore, you receive immediate tax benefits.
Traditional IRAs are open to anyone with an earned income, and the money you contribute to a traditional IRA may be tax-deductible. Your tax deduction may face limitations if you or your spouse (if you’re married) receive coverage from an employer retirement plan like a 401(k) and your income exceeds a certain level. Your deduction is fully allowed if you and your spouse receive no coverage from an employer retirement plan. For more information, refer to the IRS’s IRA Deduction Limits guideline.
Contributions to traditional IRAs use pre-tax dollars. Pre-tax means money taken from your gross pay before the government withholds taxes. Therefore, you can save money using a traditional IRA during tax season since your entire income is not taxed; you contribute a portion of your income to your traditional IRA, making it tax-deferred.
Let’s give an example:
You have an income of $50,000 and decide to set aside $3,000. Because you used a traditional IRA, that $3,000 will not be taxed. However, you’ll pay taxes on the $47,000 of your income you did not set aside. If you are in a 22% tax bracket, you would have paid 11,000 in taxes (50,000 x 0.22) without an IRA. Since you have a retirement account, you pay $10,340 (47,000 x 0.22).
As mentioned, you can buy and invest in securities within your IRA. Say you buy $3,000 of stock, it doubles five years later, and you decide to sell it. You’d have $6,000 from that sale within your IRA. Therefore, you’ve profited from contributed funds that were not taxed, and that investment profit is not taxed either.
Withdrawing from a Traditional IRA
Technically, you COULD pull money out of your traditional IRA at any time, but there is a 10% penalty and tax on the amount you withdraw if you are younger than 59 ½. Once you’ve exceeded that age, you can draw funds, but you’ll have to pay regular taxes.
Say you’re in a 12% tax bracket in retirement. If you withdraw $3,000, you’ll pay $360 in taxes (3,000 x 0.12) and have $2,640 to do with what you will. In contrast, if you did not use a traditional IRA when you were in a 22% tax bracket, you would have paid $660 in taxes (3,000 x 0.22). Therefore, you have $300 in tax-deferred savings (660 – 360).
Typically, there are required minimum distributions (RMDs) for traditional IRAs. Once the account owner reaches 72 years of age, they must make withdrawals. For more information, refer to the IRS.
What is a ROTH IRA?
With a Roth IRA, you pay taxes when you put money into the account, not when you withdraw from it later. There is no tax deferral, unlike a traditional IRA. You receive no current-year tax benefits as a result. However, you can invest from within the account like a traditional IRA.
In other words, you pay taxes when you contribute to the account, and that money can grow over many years without being taxed. Additionally, you are not taxed when you withdraw these funds after turning 59 ½.
Roth IRAs have limits depending on your income that influence your ability to contribute. As a result, you can’t contribute if you make too much money, and the limitations change depending on whether you are a single tax filer. Contributions use after-tax money, meaning those earnings have had income taxes deducted.
Let’s give an example of a Roth IRA contribution.
- Today, you decide to set aside $2,000.
- Because you used a Roth IRA, that $2,000 of your income will be taxed.
- Let’s say you’re in a 22% tax bracket. You’ll pay $440 in taxes (2,000 x 0.22) during the contribution period and have $1560 saved in your account.
One of the most important benefits of a Roth IRA is that there is no tax on gains unless you withdraw them early. You’ll never be taxed on growth outside of early withdrawals because only initial contributions are taxed.
Withdrawing from a Roth IRA
To withdraw tax-free earnings from your Roth IRA, you must wait five years after your first contribution to the account. The original contributions to a Roth IRA won’t be penalized or taxed once you withdraw them after five years. In this way, the Roth IRA is more flexible for pulling funds before retirement than a traditional IRA. However, for an early withdrawal of EARNINGS from your Roth IRA, you must pay the 10% tax penalty and regular income tax.
Once you’re older than 59 ½, you can withdraw your contributions and earnings from your account tax and penalty-free. Roth IRAs do not require withdrawals until after the death of the owner, unlike traditional IRAs.
Contribution Limits
The annual contribution limit for IRAs in 2024 is $7,000 for those under 50 years of age and $8,000 for those 50 and above. Throughout the year, you can contribute to both types of IRA accounts, but your total contribution amount must be at most the limit.
What Type of IRA is Best For Me?
Taxes. Taxes. Taxes. The answer to this question comes down to that one little word. If you want tax-free withdrawals in the future, it’s a Roth IRA you’re after. If you desire current tax benefits, consider a Traditional IRA.
A Roth IRA would benefit a person who expects to be in a higher tax bracket after they turn 59 ½. As a result of a lower tax bracket in the current day, they would avoid paying more in taxes with a Roth IRA.
If you expect to be in a similar or lower tax bracket after they turn 59 ½, you may want to consider a traditional IRA. You’d pay fewer taxes than you would have during the contribution period.
Refer to the Key Takeaways table at the blog’s beginning for a side-by-side comparison of each account. If you need help weighing your options, one of our team members will happily provide guidance. Contact us today!
