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Saving for retirement is not a big focus for most people when they’re young. There are a lot more exciting things to worry about than getting older. But the sooner you start saving and make a plan, the better.
There are several different ways to prepare for retirement and gain income outside of work. Many employers offer retirement plans like 401(k)s and pensions.
There is also Social Security benefits that may provide a source of income (but I wouldn’t count on it if you’re young).
Retirement can be a boring topic. But the bottom line is that no one wants to work their entire life. You should be utilizing tools like IRAs to ensure you’ll be able to retire.
What is an IRA?
IRA stands for individual retirement account. It is a tax-advantaged account designed for individuals to save for retirement.
IRAs allow you to manage your retirement savings yourself and offer different benefits than a 401(k).
The Different Types of IRAs
There are two main types of IRAs, a traditional IRA and a Roth IRA. There is also a Rollover IRA, SIMPLE IRA, and SEP IRA.
A traditional IRA allows individuals to make pre-tax contributions that grow tax-deferred. This means your investments can compound year after year without being taxed.
You can make after-tax contributions and pre-tax contributions to a traditional IRA. Basically, you can contribute money that you have not been taxed on and money you’ve already paid taxes on.
Once you retire, you will pay income tax (from pre-tax contributions and earnings) on withdrawals from the IRA.
In most cases, contributions made to a traditional IRA are tax-deductible. For example, if your income is $40,000 a year, and you contribute $5,000, your taxable income will be lowered to $35,000.
Roth IRAs only allow after-tax contributions and are not eligible for tax-deductible contributions. With a Roth IRA, your investments and earnings grow tax-free. Because you already paid taxes before contributing, your withdrawals are not taxed once you retire.
To be eligible for the tax-free growth, the money must be kept in the Roth IRA for at least five years.
You can withdraw contributions at any time without taxes or penalty as long as it doesn’t include earnings.
A rollover IRA is simply a traditional IRA that can receive funds from separate retirement accounts. They are commonly used to roll over a 401(k) from a previous employer.
They can then be used to roll back the funds into 401(k) with a new employer. You can also treat a rollover IRA just as a traditional IRA and make contributions without planning on rolling it back to 401(k).
A SIMPLE IRA, short for Savings Incentive Match Plan for Employees, is a retirement plan available for small businesses. An employer can set up non-elective contributions of 2% of the employee’s salary or match employee contributions up to 3%.
SEP stands for simplified employee pension. It’s an IRA available to employers and the self-employed that’s easy to setup.
With a SEP, employer contributions are instantly vested–which means employees own 100% of the contribution. Typical employee-sponsored plans can take years before the employee is vested.
Roth vs. Traditional IRA
The differences between a traditional and Roth IRA cause many to debate which one is better. In reality, one isn’t necessarily better than the other.
Like most personal finance decisions, it comes down to what works best for you personally.
Here are the major pros and cons of both:
Roth IRA Pros
- Contributions grow tax-free.
- Contributions can be withdrawn before retirement without penalty.
- No taxes on earnings.
- No mandatory distributions.
Roth IRA Cons
- No tax-deductions from contributions.
- Only after-tax contributions can be made.
- It is limited to those below a certain income level.
A Roth IRA is a good choice for someone that believes their income tax rate will be higher during retirement. This makes sense because you are paying fewer taxes now vs. expecting to be at a higher tax bracket later on.
The tax-free growth on earnings also makes a Roth IRA an appealing choice.
Traditional IRA Pros
- Pre- and after-tax contributions.
- Immediate tax benefits from eligible contributions.
- No restrictions on earned income.
- Option for rolling over a 401(k).
Traditional IRA Cons
- Earnings are taxed once you make withdrawals.
- Mandatory distributions after age 72.
- Contributions cannot be withdrawn penalty-free prior to retirement.
Traditional IRAs are better suited for those who believe they will be in a lower tax bracket during retirement. This is typically the case because you should fall into a lower tax bracket if you are no longer working.
The immediate tax benefits with a traditional allow an individual to save more while working towards their retirement goal.
You Can Have More Than One
It’s not uncommon for people to have more than one IRA. Having a traditional and a Roth IRA allows you to get the best of both worlds.
There is no limit on the number of IRAs you can have, but the annual contribution limits remain the same.
The 2021 annual contribution limit for both Roth and traditional IRAs is $6,000. This is a combined limit, so if you have more than one IRA, you cannot contribute more than $6,000 between them.
If you are 50 years old or older, you qualify for a catch-up contribution allowing you to contribute a total of $7,000.
All contributions to IRAs must come from earned income. In the eyes of the IRS, earned income can come from your business, your job, and other taxable compensation.
How to Open an IRA
You can easily open an IRA with a brokerage, bank, or credit union. It’s more common for people to use brokerages. A broker allows for more investment options than most banks and credit unions.
Most reputable brokers that offer individual trading accounts also have the option to open an IRA. Your best bet is to go with one of the industry leaders like Charles Schwab, Vanguard, and Fidelity.
Be wary of brokers that have high-fees, strict rules, and limited investment options.
IRA vs. 401(k)
Both IRAs and 401(k)s are valuable tools to save for retirement. Each one offers excellent tax benefits as well. The most significant difference is that a 401(k) is only available through an employer, whereas an IRA can be opened by an individual.
Like IRAs, there is both a traditional and a Roth 401(k).
401(k)s have higher annual contributions but often have a limited selection of investments to choose from. With an IRA, you have a lot more control over what you are investing in.
Most employers that offer a 401(k) also have a company match. If your workplace has a 401(k) with an employee match, it’s wise to contribute the maximum to get the full match.
A 401(k) match is free money that will accelerate your retirement savings. If your employer doesn’t offer a match, you can just stick to using an IRA.
Having both an IRA and a 401(k) is ideal, especially if your employer matches 401(k) contributions.
Individual retirement accounts (IRA)s are essential for building a retirement fund. They offer flexibility and valuable tax benefits that you can’t get with a regular savings account.
Utilizing an employee-sponsored retirement plan like a 401(k) is great. But, the addition of an IRA will better prepare you for your golden years.