When you’re retired, you generally have three primary sources for income: Social Security, employer pension plans, and personal savings. So plans for retirement should take all of these into account. An Individual Retirement Account (IRA) falls into the personal savings category.
A quick note about pensions (also known as defined benefit pans) — most of us don’t have one. A pension is when your employer promises to provide a guaranteed periodic payment when you retire. Employers have largely moved away from these plans simply because it’s very costly to keep this promise. If you’re one of the many people without a pension, your personal savings – like an IRA — will play a much larger role in meeting your retirement income needs.
An IRA is not an investment in itself. It’s a type of account where you have the ability to direct your investment decisions. Your investment options depend on what the financial institution where you open the IRA offers. You may be able to invest in stocks, bonds, mutual funds, exchange traded funds (ETFs), CDs, etc.
You don’t have to have an IRA (or a 401(k)) to save for retirement. You just have to save. But IRA accounts have tax advantages that can help your money grow faster.
There are different types of IRAs and they each have different rules and qualifications. The most common types are traditional IRAs and Roth IRAs.
Traditional IRA – Anyone with earned income, or married to someone with earned income, can open an IRA. For 2019, you can contribute up to $6,000 per year (or $7,000 if you are over age 50). And your contributions to a traditional IRA are pre-tax. However, your ability to deduct from your account depends on your income and if you are participating in an employer qualified retirement plan. The best tax advantage is that all the interest, dividends, and capital gains from your investments are tax deferred. That means you won’t have to pay any taxes until you make a withdrawal. Distributions are then taxed as ordinary income.
At some point the government wants to make sure they get their taxes, so you can’t keep the money in your IRA forever. You are required to begin taking required minimum distributions (RMDs) from your Traditional IRA beginning at age 70 1/2. The amount of your RMD is based on the value of your IRA account.
Roth IRA – To contribute to a Roth IRA you must have earned income, or be married to someone with earned income. But your ability to contribute to a Roth IRA phases out once your income reaches a certain amount. For 2019, the phase out begins when your annual income reaches $122,000, and once your annual income reaches $137,000 you’re no longer able to contribute at all. For married couples, the phase out begins when your annual salary reaches $193,000, and you’re ineligible when it reaches $203,000.
For 2019, you can contribute up to $6,000 per year ($7,000 if you are over age 50). Unlike a Traditional IRA, Roth IRA contributions are not tax deductible. But all interest, dividends, and capital gains grow tax free. Also unlike the traditional IRA, when you withdraw your funds from a Roth IRA, you won’t have to pay any taxes.
Another difference between the Roth IRA and the traditional IRA: You don’t have to take any RMDs when you reach age 70 ½.
There is a great benefit to having your money grow tax deferred. Outside of a tax-deferred account like an IRA, your interest, dividends, and capital gains are subject to income tax every year. As your nest egg grows and the investment returns become larger, so will your tax bill. But while your money is in an IRA, you don’t have to worry about paying taxes on your investment returns. Your money can stay right in your account and continue to be reinvested and take advantage of the benefits of compounding. You won’t have pay any taxes until you make a withdrawal.
The favorable tax treatment behind IRAs is to encourage you to save for retirement and to discourage you from withdrawing your retirement funds early.
If you withdraw funds from a traditional IRA before you reach age 59 ½ you’ll be subject to a 10% federal tax penalty on the amount withdrawn (the IRS does allow for some exceptions). This is in addition to the income tax you will have to pay.
Since your contributions to a Roth IRA aren’t tax deductible, the early withdrawal penalties are different. You can withdraw the amount contributed at any time without being subject to income tax or penalties. However, an early withdrawal of any amount greater than your contributions (investment earnings) may be considered taxable income and subject to a 10% penalty. To avoid penalties, your account must have been established for at least five years and you must be age 59 ½.
So what’s better, contributing to a traditional IRA or a Roth IRA?
The primary consideration is when you want to pay taxes. Think about what your tax bracket is now versus what it will be when you retire. If you’re in a high tax bracket now, deducting contributions to a traditional IRA now could save you money, particularly if you think your tax bracket will be lower when you retire. Remember, you have to pay ordinary income tax on your withdrawals. Unfortunately, no one has a crystal ball and knows what the tax rates will be in the future. With a Roth IRA, you won’t get the tax break now on your contributions, but you won’t have to worry about paying any taxes on your withdrawals when you retire.
Is it better to contribute to your 401(k) or an IRA?
You can contribute to both types of accounts. But your cash flow may limit to how much you can put away for retirement. So where should you prioritize? Take a look at your 401(k) first. Both are similar. Your contributions to your 401(k) are not included in your taxable income and the earnings grow tax deferred. But one key difference is your employer may make a matching contribution to your 401(k). That’s free money to you. I would contribute enough to my 401(k) to ensure I get the entire matching contribution from my employer.
Do you have a 401(k) left at a previous employer? You can move that to an IRA account. This is called a rollover. The advantage of a rollover is you have more control on how to invest your money. When left in the 401(k) plan, your investment options are limited to what the 401(k) plan offers. You can increase your investment options by rolling over your 401(k) to a financial firm of your choice with the investment options you are looking for. Another advantage to a rollover is you can consolidate your retirement assets. It’s a lot easier to make sure you have the best asset allocation for your retirement funds when they are consolidated.