Investing into your retirement is going to be one of the most important decisions that you make throughout your life. It will affect you, your family, and your lifestyle: now and when you retire.
It is never too early to start planning for retirement, no matter what stage of life you are in.
How much money is enough? What is the best way to put money aside? How do I manage the risk while still seeing a positive investment growth?
Hopefully this post will be able to answer some of these questions for you, but also make you more knowledgeable in developing your own investment strategies when Contributing to a Roth or Traditional IRA.
WHAT IS AN IRA?
Investment Retirement Accounts, or IRAs, are the most common accounts used to save for retirement. These retirement savings plans can be opened by anyone with earned income, including your children.
It takes money out of your paycheck and invests it into a wide range of accounts. These accounts typically include mutual funds, which is a combination of different stocks and bonds, or an exchange traded fund.
THINGS TO CONSIDER WHEN OPENING AN IRA
Opening an IRA is as simple as opening a new bank account. You can look to Vanguard, Fidelity, E*TRADE, or Charles Schwab to choose which investment firm you would like to use to open your account.
The best approach is to pick a target date fund that is usually based on when you would plan to retire. These funds incrementally decreases investment in stocks and increases investment to bonds as your retirement date approaches.
For example, if a 25 year old is opening an account today, they would choose a Target Date fund around 2060. This means that initially, the Target Fund will be investing more heavily in stocks early on since you have the ability to take more risk.
As you approach retirement, the Fund will rebalance automatically, and invest more heavily in bonds, which are lower risk. This manages your risk automatically which offers a hands-off approach to investing.
TWO TYPES OF IRAs
There are two main types of IRAs, the Traditional IRA and the Roth IRA. Let’s provide more details about each one and see which of the two makes the most sense for you.
Traditional IRA | Roth IRA | |
Income Limits | None | Single: $139,000 Married: $206,000 |
Yearly Contribution Limit | $6,000 a year if under 50 $7,000 a year if over 50 | $6,000 a year if under 50 $7,000 a year if over 50 |
Contribution Growth | Tax-Deferred | Tax-Free |
Contributions Come From | Pre-Tax or After Tax Dollars | After Tax Dollars |
Immediate Tax Benefits | Contributions are Tax-Deductible | None |
Future Tax Benefits | None | Withdrawals are NOT taxed at Retirement |
Withdrawal Requirements | Must start withdrawing at 70.5 | None |
Withdrawal Limits | 10% penalty if you withdraw money before 59.5 | Withdraw contributions at any time. 10% penalty and federal tax penalty if you withdraw money before 59.5 |
Exceptions | None | First time Home-Buyer Higher Education Expense Medical Expenses |
Best Suited For | Individuals who expect a LOWER tax rate at retirement | Individuals who expect a HIGHER tax rate at retirement |
TRADITIONAL IRA
Traditional Investment Retirement Accounts can be a smart solution to increase your tax deferred retirement account.
These accounts take money out of your paycheck before taxes, and put it into your retirement account, giving you immediate tax benefits if your contributions are tax-deductible.
As your account grows, you will start to realize your investment gains. When you take money out of your retirement account once you reach your retirement age, you are required to pay ordinary income tax on all of the investment gains and all of your contributions.
A Traditional IRA is best suited for you if you expect to be in a lower tax bracket when you retire.
ADVANTAGES
- More money initially into your account because you do not pay taxes on contributions
- Receive immediate tax benefits
- No income limits for opening this type of account.
- Can contribute up to $6,000 a year if you’re under 50 ($7,000 a year if you’re over 50)
- Anyone with earned income can open an account
DISADVANTAGES
- Required to start taking distributions (withdrawing money) at age 70.5
- Cannot contribute money after age 70.5
- There is a 10% penalty if you withdraw money before 59.5
- You pay ordinary income tax on all withdrawals (usually your income tax rate is higher when you retire)
EXAMPLE
Let’s assume a starting salary of $80,000 which puts you in the 22% tax bracket.
If you decide to invest $5,000 a year into a traditional IRA, that $5,000 is tax-deductible which saves $1,100 a year in taxes. After 30 years of working, and assuming an investment return of 9% (which is the average stock market increase per year), your retirement balance will be $681,537.
Say your salary went up to $90,000 by the time you retired. Your new tax rate would increase to 24%. This means the value of your IRA is now $517,968 because you have to pay ordinary income tax on everything that you want to withdraw at your current 24% rate.
The highest performing brokerage account for opening a Traditional IRA that I have found is E*TRADE. They constantly outperform the S&P and have a wide variety of accounts to select from. Click here to start an E*TRADE Traditional IRA Account today
ROTH IRA
The other option available when investing in an IRA is the Roth IRA. Once you understand how this strategy works, you’ll realize the advantages to this retirement tool and investment strategy.
The Roth IRA is an individual retirement account that you contribute after tax dollars. Your money is taxed from your paycheck right before you put it into your retirement account.
As your account grows and you realize the investment gains, you are NOT taxed on those gains when you take the money out after retirement.
It’s free money! So you are taxed at first, and then your account grows tax free after that.
A Roth IRA is best suited for you if you expect to be in a higher tax bracket when you retire.
ADVANTAGES
- More money when you retire because your contributions grow tax-free
- No Tax on Investment Gains
- Can contribute up to $6,000 a year if you’re under 50 ($7,000 a year if you’re over 50)
- No mandatory distributions (withdrawals) at any age
- Contributions can be made at any age
- Withdrawals can be made penalty-free and tax free after age 59.5
- No income tax on inherited Roth IRAs
DISADVANTAGES
- Income limits exist for contributing into Roth IRA
- Do not receive current year tax benefits
- There is a 10% penalty if you withdraw money before 59.5
EXAMPLE
Let’s look at our example from above and see how our money grows differently.
Our starting salary of $80,000 still puts us in the 22% tax bracket.
The $5,000 that you want to invest is actually only $3,900 because you pay $1,100 a year in taxes. After 30 years of working, and still assuming an investment return of 9%, your retirement balance will be $531,600.
If your salary still went up to $90,000 by the time you retired, it does not affect your retirement account because you were already taxed on this money, it grows tax-free. That is an EXTRA $13,632 in your retirement account!
This simple example shows that you end up with significantly more money in your retirement account if you invested in a Roth IRA.
INCOME LIMITS
As mentioned above, not everyone will qualify for contributing to a Roth IRA because there are income limits to this investment strategy.
For 2020, if you are filing Single, and your Modified Adjusted Gross Income (MAGI) is under $124,000, then you can contribute up to the maximum amount of $6,000 per year. If your MAGI is between $124,000 and $139,000 a partial contribution is allowed, somewhere between $6,000 and $400 a year. If your MAGI is above $139,000, then you cannot invest into a Roth IRA.
If you are married and filing jointly, and your Modified Adjusted Gross Income (MAGI) is under $196,000, then you can contribute up to the maximum amount of $6,000 per year per person. If your MAGI is between $196,000 and $206,000 a partial contribution is allowed, somewhere between $6,000 and $400 per person a year. If your MAGI is above $206,000, then you cannot invest into a Roth IRA.
FIRST TIME HOME BUYER BENEFIT
An additional benefit of opening a Roth IRA is that you are allowed to use the money in this retirement account towards the purchase of your first home.
As long as your account has been open for five years, you are able to use any of the money that you contributed into the account as well as up to $10,000 of any of the investment gains to purchase your first home.
The 10% withdrawal penalty and federal tax penalty are waived.
It is important to remember that you are only allowed to take advantage of this benefit if your Roth IRA has been open for five years.
If you open the account in November 2020, you will meet this 5 year requirement in January 2025. One month of a year counts as being open for the entire year.
HIGHER EDUCATION EXPENSES BENEFIT
An additional benefit of opening a Roth IRA is that you can utilize the contributions and investment gains from a Roth IRA to pay for qualified education expenses without having to pay the 10% early withdrawal penalty and federal tax penalty.
Qualified education expenses include tuition, fees, books, supplies, and room and board at any College, University, Vocational School, or other post-secondary educational institution. This applies to you, your spouse, your children, and even your grandchildren.
WITHDRAWAL FREEDOM
It is important to remind you when dealing with your Roth IRA, you are allowed to take out any of the money that you put in, at any time, without penalty.
However, you need to wait until you turn 59.5 to take out any of your investment gains if the above exceptions do not apply to you.
If you do take out investment gains early, you are subject to a 10% penalty in addition to being subject to federal income taxes since you didn’t wait until the minimum retirement age.
E*TRADE also has the highest performing Roth IRA accounts as well that continue to outperform the S&P 500. Click here to start an E*TRADE Roth IRA Account today.
LESSON LEARNED!
The first step to planning for a successful retirement is to start now!
Even if you can only contribute 1% or your salary, the advantages of getting some money into the market will start the process of compounding interest and investment gains early.
Contributing to a Roth or Traditional IRA is a very important step on your road to retirement. The sooner you start investing, the quicker you can start watching your money work for you.
Eugene is a Chemical Engineer with a passion for personal finance and is constantly learning new tricks to make his money work for him. He obtained an MBA part time and hasn’t stopped finding ways to make money, save money, and properly invest money. He currently lives at the Jersey Shore with my wife and two children.