Don't have access to a 401(k), 403(b) or other tax-advantaged accounts? Good news...anyone can open up an Individual Retirement Account (IRA) to invest in their future, while also taking advantage of some potential tax breaks. Along with a quick overview, this article takes a look at two popular options—Traditional and Roth IRAs.
How Do IRAs Work?
IRAs are essentially a personal 401(k) that is controlled completely by you. This means you decide when to deposit the money, and more importantly, where. Unlike work-sponsored retirement plans that go through your employer's bank, you choose the financial institution with which to open your IRA. Unfortunately, IRAs only allow $5,500 in annual deposits (or $6,500 if you're 50 or older), far less than the $18,000 limit of many 401(k)s.
A traditional IRA is incredibly similar to a 401(k) because your contributions are tax deductible (unless you have a 401(k) at work as well, in which case deductions may be limited). Tax implications do not simply disappear, however, but are deferred. Decades later when you withdraw any invested money from the IRA, you will pay regular income taxes. The idea is that you will be in a lower tax bracket by the time you start to utilize your IRA funds.
Anyone below the age of 70 1/2 with a taxable income can open a traditional IRA. Similar to 401(k)s, you are required to start withdrawing minimum amounts from the account after the age of 70 1/2.
Roth IRAs provide a unique tax advantage. The money added to a Roth IRA is NOT tax deductible the year it is deposited. However, when the money and accrued gains are withdrawn many years down the road, it is completely tax free in retirement (starting after age 59 1/2).
While a traditional IRA puts off taxes until retirement income in the future. In other words, pay now, save later.
Roth IRAs also offer flexibility that traditional IRAs and 401(k)s can't. With a ROTH IRA, you can withdraw up to the amount you have deposited completely tax-free and penalty-free at any time, no matter the reason. In addition, you may contribute to your ROTH IRA after the age of 70 and there are no mandatory withdrawals regardless of age.
On the other hand, not everyone is eligible for a Roth account. If your income is higher than $117,000 (or $184,000 if married filing jointly), then you are not eligible for a Roth IRA.
Which is right for me?
Ultimately, your decision comes down to tax deferral vs. post-tax money to invest. Depending on your financial situation both now, and in the foreseeable future, one might be more advantageous for you than the other. Ask your tax advisor to help you make a smart choice. Regardless, the single most important thing you can do for your future is to begin saving for retirement, no matter the type of plan.