Individual Retirement Account is a place where you can put money you are saving for retirement. And, there are two basic kinds: Roth IRA and Traditional IRA . How do you decide which one you should choose?
Over the years there’s been a lot of talk about the importance of putting money away to save for retirement. I couldn’t agree more with this thought process. Planning for retirement is one of the smartest things you can do for yourself.
Some of you may be working jobs that include a work savings plan like a 401(k), or 403(b). Others may be self-employed and have the option to open a SEP (Simplified Employee Pension). And, others may not qualify for any of those and this is where the IRAs come into play.
TRADITIONAL IRA
First, let’s talk about the Traditional IRA. This is a plan that allows you to deposit your money into a specific savings account to avoid paying taxes during the year you earned the money. This is considered a tax deferred IRA. If you put $5,000 away in a traditional IRA in the year 2020, the $5,000 will not be included as part of your taxable earned income for 2020. You are deferring your taxes (on that $5,000) until the time you start to withdraw it, usually during your retirement years. The school of thought over the years is that you will ‘probably’ pay less income tax after retirement than during your working years. So, if you start to withdraw it during retirement years and you have less income than you did during your working years, you hopefully will be in a lower tax bracket and pay less tax on the $5,000. However, if your money has been invested in something that has increased the value, you will then have to pay taxes on the total amount, not just the $5,000. If the value of your initial $5,000 investment increased to $8,000, you then have a tax liability on the entire $8,000 when you withdraw it.
ROTH IRA
The other type of IRA is called a Roth IRA. When you invest money in a Roth IRA, it is AFTER tax dollars. Using the example above of $5,000, you will get no tax advantage the year you earned the money, so it will not reduce your tax responsibility for that particular year. However, if you leave that money in your Roth IRA for a long time, it will continue to grow in value, and when you decide to withdraw it, you pay NO income tax on any of it. You already paid the tax on the 5,000 the year you earned it. If it grows to $8,000, there is no tax consequence for the additional $3,000 you earned over the years.
WHICH IRA SHOULD YOU CHOOSE?
So, how do you decide which is best, the Traditional IRA or Roth IRA? If you are a high income earner, you may consider using the traditional IRA method of savings. When you make a lot of money, your tax consequences are higher. And, your higher income can boost you into a higher tax bracket. However, people who are high earners have other ways to protect their income and that should always be researched. Tax laws change pretty regularly and it is very important to stay informed. This year, for example, the issues around the Covid-19 Pandemic has caused some of the tax rules, etc. to be changed.
If you don’t make a lot of money and maybe you are just starting your career, you may want to consider a Roth. If you are in a lower tax bracket, you may not be hit as hard with taxes compared to later years. So choosing a Roth may be in your best interest. The longer you have your money put away in a retirement plan, the better chance it will increase in value and a Roth lets all that money grow, tax free. And, honestly, if you do a good job planning financially for retirement you will probably be in a higher tax bracket in your retirement years than you were at the beginning of your working years. And all of your money invested in a Roth will have no tax consequences.
Regardless of what choices you make to plan for your retirement years, the most important thing is to start early and stay the course. As your financial situation improves, be sure to chat with a financial expert to guide you along the way. I caution you, though, be educated and informed about the choices you have, even when consulting with an advisor. This is your money, and it’s really up to you how you want to plan. Start young, learn as much as possible about YOUR MONEY, and know that good financial planning will be a real comfort during your senior years. If I had it to do all over again, I would choose a Roth for all my IRA contributions.
A FEW MORE THOUGHTS
The example above only addresses personal IRAs for individuals. There are now programs for work place savings that include a Roth option for 401(k) and 403(b). Each year the annual amount you can contribute may change. These contribution limits vary from a personal account to a work place account. Typically, each year the amount you can contribute usually goes up.
If you have a life changing event that affects your finances, remember you can make changes to your saving plans any time you want. NOTE: Do everything in your power to not withdraw your retirement money along the way. And, it's best not to borrow against it. This is retirement money that you will be very pleased to have when it comes time to start withdrawing it.
Also, be sure to educate yourself on what happens to your accounts when you pass away. There are different rules for inherited IRAs.
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