Saving for retirement isn’t hard. Getting started is. Gone are the days when workers could count on an employee pension plan and Social Security to cover their costs during those golden years. Today, pensions are a rarity and Social Security isn’t a slam-dunk for future generations since we have an aging population and fewer workers paying into the system.
Because of this, Uncle Sam wants/needs YOU to save for retirement. Offering tax breaks on retirement plans is the government’s way of enticing us to set aside money and employers to help out. This post is going to focus on Individual Retirement Accounts.
Traditional vs. Roth IRAs: Understand the Retirement Planning Benefits of Each
The IRA is the big kahuna of retirement savings plans. IRAs come in two main varieties — traditional and Roth. You can have one or the other, or both depending on what tax handling you think will work best for you.
The IRS limits how much an individual can contribute to an IRA each year, and depending on the type of IRA, decides how the funds are taxed — or protected from taxation — when a participant makes deposits and withdrawals.
When you contribute to a Traditional IRA, you’re potentially using pre-tax dollars that can help lower your taxable income. So, for example, if you make $60,000 and end up contributing $5,500 to a Traditional IRA over the course of a year, the IRS may tax you on only $54,500 of income. This means contributing can decrease your taxes today — but you’ll have to pay those taxes when you take money out in retirement.
The other important thing to know is that with a Traditional IRA, your taxes are deferred—that means that while you may get a tax deduction now, you will pay taxes on both your contributions and any investment growth when you withdraw your money in retirement. (Withdrawing your money younger than age 59½, however, could subject you to an additional 10% tax penalty—the point of an IRA, after all, is to help you save for retirement.)
With a Roth, you don’t get any tax deductions on the contributions you make now. In other words, if you want to place $5,500 in a Roth, you’re using post-tax money. The good news? Your withdrawals in retirement—including any investment growth—is tax-free, assuming your withdrawals are done at age 59½ or older, and you’ve owned your Roth account for at least five years. This means you get no tax savings today, but you do get to take money out tax-free in retirement (as long as a few criteria are met). Be sure to understand the income restrictions and limits on contributions, though.
For instance, if you’re married filing jointly with a modified adjusted gross income of $196,000 or more, you can’t contribute at all to a Roth IRA. If you make less than $186,000, you can contribute up to the full limit. If your income falls somewhere in between, you’ll be allowed to make a reduced contribution based on an IRS formula.
Main Advantages of IRAs
- They put you in the driver’s seat. You choose the institution and make all the investment decisions, or can seek a financial advisor to make them for you.
- Depending on the type of IRA you choose — Roth or traditional — and based on your eligibility, you decide how and when you get a tax break.
- IRAs provide a much wider range of investment choices than workplace retirement plans do.
So which one do I choose?
That, of course, totally depends on your individual situation, but one of the big considerations tends to be what your tax situation is. It’s crucial to weigh your options carefully and IRA rules can be confusing. It may be wise to engage a qualified tax advisor or financial planner to help you make sure you’re setting them up correctly and figure out the best strategy for you. >> Get started today!