Today’s consumer has a lot of options for retirement planning. Most people know that they cannot rely on Social Security as a form of retirement income and need to open an account to begin building their own savings. Retirement accounts, including the Individual Retirement Account, or IRA, offer special benefits other investment accounts do not. Because they have the specific goal of allowing you to save for retirement, there are tax advantages to using these accounts.
How Does an IRA Work?
It’s important to understand that each type of retirement account is a bit different both in how you fund it and in when you can withdraw the funds. The taxation on these accounts also differs from one to the other. An IRA is a product for those who may not have access to an employer-funded retirement account, such as those who work for themselves. If you have an employer-sponsored account, such as a 401(k), you may still want to consider opening an IRA to supplement those goals. Note, if you work for yourself or are a small business owner, you may need to learn more about a SEP IRA.
These accounts allow you to deposit money into them over the course of your working years. When you enter retirement, you are then able to withdraw the funds to use for anything you need. Now, there are two different types of IRAs, both of which have very different styles of taxes.
The Roth IRA
With a Roth IRA, you are depositing money into your retirement account after it has been taxed by your employer. These are after-tax dollars. The funds go into your account and buildup up over your lifetime. When you reach retirement age, you can begin to withdraw the funds and use them as you need to. When you withdraw them, there are no taxes paid on the funds you take out. That means even the funds you earn due to interest and your underlying investments doing well are not taxed then.
The Roth IRA is ideal if you believe your tax rate will be higher when you are older than it is now. This type of retirement account is only available to people who have an income threshold below a certain level. This changes every year. For 2019, for example, if you earn less than $193,000, you can contribute to a Roth IRA and contribute as much as $12,000. There are step-down levels beyond this.
The Traditional IRA
The second type is a traditional IRA. It is available to most people. One of the key advantages of this account is that you can open it no matter what your income is. However, you have to be under the age of 70 and ½ years of age to do so. At the point of reaching this age, you must begin to withdraw funds from your traditional IRA. These are called required minimum withdrawals. The amount you must withdraw depends on your age and the balance in your account.
The taxes on a traditional IRA are also a bit different. With a traditional IRA, the deposits you make are made pre-tax. That means that before your employer pays any taxes on your income, a deposit is made into your IRA. The funds grow in your retirement account for the years you are working. Then, when you are ready to start pulling the money out during your retirement, the taxes are applied.
If you believe you will have a lower tax rate when you are older – which is very common for most people – the traditional IRA works. You would pay lower taxes then than you would if you paid those taxes now.
Tax Deductions with IRAs
Another way to benefit from an IRA is through tax deductions. However, there are limits here. While most of the benefits of retirement accounts come from your retirement years, there is also a benefit that can apply to you every year.
With a traditional IRA, you are able to deduct the amount of money you put into your IRA from your income taxes. For example, let’s say you deposit $1,000 into your traditional IRA during the year. You can reduce your taxable income by $1,000 as a direct result of this.
There are some limits. Every year, there are specific amounts that you can deposit and claim on your taxes. For 2019, you are able to deposit up to $6,000 into your retirement account if you are 49 years of age or younger. If you are over 50, you qualify for catch-up investments. In this case, you can deposit as much as $7,000 into your account and deduct that amount from your taxable income.
Keep in mind that if you have a Roth IRA, your contributions to your account are not tax deductible during your earning years. That is, you are not able to receive any tax deduction for those investments.
Yearly Contribution Limits
The federal government recognizes the benefit of offering these types of tax-advantaged accounts to residents. The discounts you get in taxes are meant to support your retirement goals. However, there are limits on how much you can contribute.
Both the traditional and the Roth IRA have the same types of yearly contribution limits. Each year, you can deposit as much as $6,000 into your account if you are under the age of 50. If you are over the age of 50, you can contribute up to $7,000 (these are 2019 figures).
Withdrawing Your Contributions from Your IRA
Now, let’s say you are getting older and are ready to start withdrawing funds from your retirement accounts. You can do that with both forms, of course. However, there are some differences here.
Roth IRA Withdrawals
You can withdraw funds from your Roth IRA at any time. That is because, with this account, you have already paid taxes on them. Keep in mind that if you pull money out of your Roth IRA before the age of 59.5, though, you will pay a 10 percent tax on the funds. This works as a type of penalty and is designed to discourage people from withdrawing funds from their IRA for any type of use. Nearly all types of retirement accounts have this penalty associated with them.
Traditional IRA Withdrawals
For those who decide to take the traditional IRA route, you are not able to withdraw funds from your retirement account until you reach the age of 70 ½ years of age. If you take the funds before this time, you are charged the same 10 percent penalty.
What Happens When There Is a Hardship?
There are times in life when we simply need to be able to access the funds in a retirement account and paying that penalty can seem very difficult to do. There are some hardship situations that would help you to avoid those costs.
For example, if you are facing the need to fund a medical need or you cannot work due to an injury, this may qualify as a hardship. There are also instances in which you can borrow the funds due to other hardships such as college expenses. The key here is to talk to your brokerage before you plan to do this to eliminate the risk of having to pay for penalties on your withdrawals.
How Does an IRA Make Money for You?
IRAs seem simple enough, but they can be complex. Like all investments, there are risks to them. When you invest in an IRA, the money you put into your account is being used to invest in other companies and various funds. The rate of return is very much dependent on how well those underlying investments do.
The ultimate goal is to deposit money into your account on a consistent basis. As you do, the money is then invested and grows in value over time. However, there is a risk component here. You may be able to choose riskier underlying investments, such as stocks with a higher potential return but more risk to them. If you are getting older, you can change the allocation of your investment to safer stocks or an ETF that may not earn as much but are less likely to lose money for you.
The rate of stock returns on your IRAs is a big factor in how much you earn. However, so is compounding interest. When you put money into the account, it grows in value. That money remains there long term. That means after the interest is earned, your initial investment continues to ride along with the interest you’ve earned. Compounding interest builds value faster, allowing you to earn more.
It’s important to work with your broker to ensure you are choosing the right stocks and investment strategies to meet your goals. Even if you are managing your IRA on your own, it’s important to research the individual stocks within the portfolio to ensure they fit your financial needs and risk tolerance.
How to Choose the Right IRA for Your Needs
It’s hard to say which type of IRA is right for you. To make this decision, you need to consider your overall goals and circumstances. Consider the following.
It’s easy enough to say that if you are young, you’ll benefit the most from a Roth IRA because you are paying with after-tax dollars. You have a lot longer for your money to grow in value, meaning more potential for tax-free withdrawals later. If you are older, you have less time for the value to increase before you need to withdrawal and begin using your account’s funds. For that reason, a traditional IRA is a better option.
Your Likely Tax Bracket
As noted, taxes are applied at different times. Let’s say you expect to be paying higher taxes now, which is rather common. After you retire, your income drops and that means less taxes and a lower tax bracket. If this is your likely situation, a traditional IRA is best to beat the taxes. If you think your tax bracket will be higher when you are ready to retire, you may want to consider a Roth IRA.
For those who want to be able to apply tax deductions to their current income tax, a traditional IRA is the only option. This is best if you want to reduce your current tax liability to make paying taxes easier for you right now.
Making Your Decision
Keep in mind that both the traditional and the Roth IRA can be used at the same time. For some people, this offers the best combination of options. It is also important to consider what your other retirement options are, including your Social Security income, pensions, or other retirement accounts from your employer. This can help to reduce your overall risks of not having the funds you need later in life after you’ve decided to retire. Having either account, though, can offer key advantages to you than having nothing in place.