I want to make sure you’re getting the most from your hard-earned dollars that you’re saving for retirement. Let’s start by defining IRA: Individual Retirement Account. Each person can establish their own IRA. This is a simple, effective, and easy way to start putting money into a retirement account.
You need to know there are two kinds of IRA’s: Traditional IRA and Roth IRA.
You might be asking yourself, what’s the big deal? Is there that much difference? There is! The difference between a Roth and Traditional IRA is when you want to pay the taxes.
With a Roth IRA you pay taxes on contributions now and get tax-free withdrawals later. In other words, you contribute after-tax dollars, your money grows tax-free, and you can take tax-free withdrawals after age 59 ½.
With a Traditional IRA, you deduct your contributions on your taxes now, and pay tax on your withdrawals later (usually after age 59 ½). In other words, you contribute after-tax dollars, your money grows tax-deferred, and all withdrawals are taxed as current income after age 59 ½.
To contribute to either a Roth or Traditional IRA, you must have earned income, and the maximum you can contribute for 2020 is $6,000, ($7,000 if 50 or older) per person. The same limits apply to 2021.
If you aren’t working, but your spouse is, you can open a Spousal IRA (either Roth or Traditional). Just make sure your spouse has adequate earned income for the maximum contribution.
While both account types are powerful tax-advantaged ways to save for retirement, there are some key differences between them:
| Roth IRA | Traditional IRA | |
| Taxes | If you believe your tax rate will be higher when you retire, choose a Roth IRA to pay taxes now and not when you’re in a higher bracket. Young gals, this is you! | If you believe your tax rate will be lower when you retire, choose a traditional IRA to save on taxes today and pay at a lower rate later. If you’re at the peak of your career, this is for you. |
| Income restrictions | If you are in a higher income bracket, your eligibility may be limited. (Check out the IRS guide to Roth IRA income limitations.) | If you are in a higher income bracket or have access to a workplace retirement plan (or your spouse does), your tax deduction may be limited. (IRS guide) |
| Early withdrawal penalties | Roths offer no penalties on withdrawals of contributions, though earnings withdrawals may be taxed and penalized if certain conditions aren’t met. | All unqualified early withdrawals before age 59 ½ are subject to a penalty of 10%. |
| Required minimum distributions | There is no requirement to take distributions unless the account has been passed to an heir. | Beginning at age 72, your account will be subject to required minimum distributions. |
Making the decision
It’s possible the table above made the choice clear for you — and it’s also possible you may still have no clue which is right for you. If you’re still in the dark, give me a call to chat about which one is right for you.
WHEN A ROTH MAY MAKE SENSE
If you’re currently in a low tax bracket — anything in the low 20% range or below — a Roth IRA is probably a good choice. (See income tax brackets if you’re unsure where you stand today.) This is more likely the case if you’re in the early stages of your career, or you’ve changed careers and will be at a higher rung of the income ladder when you retire.
Why a Roth? Withdrawals from a Roth IRA in retirement are not subject to income tax. This is a big deal! So when you start drawing income from your Roth IRA savings in retirement, you won’t have to pay income taxes to the IRS when your tax rate has gone up.
WHEN A TRADITIONAL IRA MAY MAKE SENSE
If you’re in a high tax bracket or close to retirement age, a traditional IRA makes the most sense. Why? A traditional IRA enables you to take a tax deduction when it benefits you most. When you’re in the higher income earning years paying higher taxes. And presumably a traditional IRA can save you again on the backside because you’re taking out that money when you’re in a lower tax bracket in retirement.
That’s the big question, when will my tax bracket be highest? In my earning years or in retirement?
Whichever one you choose, it’s important to start saving NOW because the sooner you save, the more compound growth you will achieve. It’s ok to start saving with a small amount, just keep increasing it. And make your contributions automatic, out of your paycheck or checking account before you can spend it on anything else, like a pair of shoes, or earrings, or?
Who doesn’t want to see their “pot of money” growing? Pay yourself, not the IRS and save for your financial security. Your future you will thank you!
Don’t know how to “squeeze” $20 a month out of your budget, give me a call so we can chat and make it happen.