If you’re like most people, your idea of a perfect evening doesn’t involve sitting down with a cup of hot chocolate and a 1,500 page investment banking book. The letters “IRA” might even strike as much fear in your heart as the letters “IRS.” Nevertheless, you still need to know what an IRA is, and most importantly, which IRA will be the best choice for your particular financial situation. Are you a recent college graduate? A single mom? No matter who you are or what your finances are like, choosing the right IRA will help make your money multiply and ensure a secure retirement.
Financial planning for your future is something you should start doing as early as possible. If you think about it, beginning to save right after college could make you a millionaire by the time you’re 65. However, it’s not always feasible to put money away when you’re just starting out in life. You need furniture, there are school loans to pay off, and it’s hard to save when you’re on an entry-level salary, scraping by with just the essentials. So how do you start putting money in an IRA with all these bills? And which IRA is going to work best for you?
An IRA works like this: you are allowed to make a maximum contribution of $4,000 (or $5000 if you are older than 50) to the IRA every tax year.
Although there are about eleven different IRAs to choose from, the two most prominent (and also confusing) ones are the Roth and “traditional” IRAs. You may have heard great things about the Roth IRA, but what in the world is it, anyway? And how do you know if it’s better for you than the traditional IRA? Well, that depends on your salary, filing status, and availability of other retirement plans like the 401k that you may receive through your job. Though both the traditional and Roth IRAs grow via compound interest, the two have essential differences.
The traditional IRA is held at a bank or brokerage firm and your money is invested in common stocks, mutual funds, or other investment vehicles. You make “principal contributions” and receive “earnings” on your contributions, otherwise known as interest. For example, if you earn $45,000 in a year and contribute the maximum contribution of $4,000 to your IRA account, you can deduct that from your taxable income and pay tax on just $41,000.
But here’s the catch—once you begin withdrawing funds when you become eligible at age 59½, guess what happens? You have to pay taxes on all the capital gains, interest, dividends, etc., for all those years you got off scot-free. So basically, if you have a hunch that you’re going to be in a lower tax bracket in retirement than you were during your working years, the traditional IRA is the way to go, since you won’t have to pay as much in the long run.
With the traditional IRA, you’re going to get the tax advantage immediately. If you need the deduction now, a traditional IRA is more advantageous to you since Roth IRAs are not tax-deductible.
All this talk about tax deductions is probably sounding pretty good to you right now, but the deductibility is not guaranteed. Your income, filing status, contributions to a company retirement plan such as a 401k plan, and spouse's retirement plan options may affect how much you can deduct. Since numbers and requirements change yearly, the following table should be used only as a guideline:
|If you are ...||Contribute to a plan at work||Do not contribute to plan at work|
|Single (or Head of household)||
Income=$51,999K or less—Full deduction
Income > $62K—No deduction
|Full deduction regardless of income|
|Married, filing jointly||
Income < $82,999—Full deduction
Income = $83–166K—depends on income and plan participation for either or both spouses
|Income = 0 – >$165K—Full deduction|
Though there are some exceptions, withdrawals cannot be taken without penalty until age 59½. Once you reach the age of 70½ (don’t worry, you don’t have to count the exact days, it just means by April 1st after you have reached age 70), you must start making minimum withdrawals. If you don’t, your IRA is subject to a 50% excise tax on the amount that should have been taken, but wasn't. Again, there are some exceptions, but typically by the time you hit 70, plan to take the total divided by your life expectancy as your minimum. Again, there are different scenarios depending on your individual circumstances. The IRS has a fairly long description of the many contingencies that could affect your IRA and its accrual, tax deductibility, and distributions.
Created in 1998, the Roth IRA is like the traditional IRA in that you contribute a certain amount every year which then accrues compound interest. However, the Roth IRA is not tax-deductible. So if you deposit $4,000 into your Roth IRA with an annual income of $45,000, you would pay taxes on $45,000. Once you start making withdrawals, the money is not taxed, which includes the earnings you’ve made on it. If you can afford to do without the tax break now that you’d get with the traditional IRA, or you think you’ll be in a higher tax bracket after retirement, the Roth IRA might be a better choice for you. Here are some other advantages to a Roth over a traditional IRA:
For the purposes of illustration, the income limits for the Roth IRA are as follows:
Obviously, this is a lot to take in all at once. To make it a little clearer, here’s a summary of the pros and cons.
If you’ve made the decision to convert your traditional IRA into a Roth, you'll have to pay taxes on all the money that was previously tax-deferred including earnings. By following the steps outlined by your financial advisor, you can rollover your traditional IRA to a Roth without penalty.
If you are decades from retirement, expect to have a high retirement income, or have minimal IRA assets (where the taxes wouldn't be too bad) it might make sense to convert.
On the other hand, if you are reducing your footprint, downsizing your lifestyle, and expect to have limited assets (and some people have successfully figured out how to have both a happy and sustainable life doing this) then converting a traditional IRA might be unnecessary.
Our goal is to provide a high level answer to a very complex topic. We are not financial planners or experts. Financial planning and tax law are moving targets and change constantly, so the best advice we can provide is take everything you learn with a grain of salt, be cautious, and work with qualified professionals when investing your hard-earned money.
For more information on this very important subject, check out the US Internal Revenue Service website pertaining to retirement earnings at www.irs.gov/retirement/. For more information concerning your specific circumstances, a reputable, qualified financial planner, accountant, or legal advisor can help.