IRA Basics: Traditional & Roth
While it’s extremely important to save for short & mid-term expenses, it’s wise not to forget the importance of long-term savings and planning—specifically, saving for retirement. Don’t fall for the myth that saving for retirement should begin at some later date. Like, “when you’re established” or “after you buy a house” or "once you have a steady career." As the saying goes, “The best time to start saving for retirement was yesterday.” You might already have a retirement savings plan with your employer (401(k), 403(b), etc.) but there are other ways to build up your retirement savings in addition to your employer’s plan. An Individual Retirement Account (IRA) gives you great tax benefits and is an integral part of your retirement plan. Also, if you aren't taking advantage of an employer sponsored plan, sign up as soon as you can!
One important concept to understand is that an IRA is not an investment. Rather, an IRA functions as a tax-sheltered account that holds whatever investment vehicles you chose. As you save, year over year, your account should grow thanks to interest and dividends reinvesting along the way. As times change, workplace pensions are becoming much less common while freelancers and independent contractors increase in the workforce. This puts much of the responsibility of saving for retirement in your hands. A good rule of thumb is to contribute between 10-15% of your gross income into a retirement account. (This includes the amount that you contribute to your employer sponsored plan.) Once you reach age 59 ½ you’re able to withdraw from the account free of any IRS penalties.
There are several types of IRAs, but I’m only going to mention the most common types here today: the Traditional IRA and the Roth IRA. For 2021, both allow you to save up to $6,000 per year, or $7,000 if you’re over 50 years old (known as a “catch up contribution”), in addition to the contributions you might be making at work in a 401(k) plan. The main difference with these types of IRAs has to do with when you pay taxes (Not if. As the other saying goes, “nothing is certain, but death and taxes.”)
These accounts generally allow you to deduct contributions on your tax returns. Your contributions are made with pre-tax dollars. This is a great way to possibly lower your tax bill in a given year. Essentially, enjoy the tax break when you make contributions now, and pay taxes later when distributions are made during retirement. If you expect to pay less in taxes during your retirement years, this is the best option for you. Of course, predicting your tax bracket after age 59 ½ is not that simple and we can help you decide if this is the best option for you.
With a traditional IRA, there are no income limits to participate; however, there are some limits to the amount you’re able to deduct from your taxes in a given year. (You can see the income limits for 2021 here.)
Penalties can be incurred with a traditional IRA if you decide to take money out before you reach age 59 ½. So, we advise you to contribute money solely for the purpose of living during retirement years. Lastly, these accounts require the owner to make withdrawals at age 70 ½ or age 72, depending on your birthday. (more information about that here) These required minimum distributions (RMD) do not apply to Roth IRAs.
Unlike a traditional IRA, contributions to a Roth IRA are not tax deductible. Funds are added to these accounts with after-tax dollars and you never owe taxes on the growth or the income. So, opposite of the traditional IRA, you pay taxes now and don’t pay taxes when you start making distributions during retirement. These accounts are often great for young people just starting in their careers.
The other benefit of a Roth IRA is that you’re able to take out money you contribute without tax or penalty because you’ve already paid taxes on that money. Here are a couple of other rules to consider with this: If you withdraw investment earnings, you may be taxed on penalized. Once you hit age 59 ½, you can only withdraw funds you have held in the account for at least 5 years. After that, you can withdraw any amount, including investment earnings without paying federal taxes.
Roth IRAs do have some income limits. While there are tax strategies available to circumvent these limits, here are the income limits for 2021. Let us know if you have questions about this and we can guide you with a plan. Also, these accounts can be opened at any age, as long as you have earned income. (Put that lemonade stand money to good use!)
It’s easy to see age 59 ½ as the end of your retirement savings years and the beginning of retirement distributions, however, this is not completely true. This age is merely a number set by the IRS. In reality, people are working well into their 60s and 70s and are living much longer sometimes reaching 90 or beyond! This means it’s important to save more and to start earlier. The likelihood of your living to age 100 is increasing each year!
A general goal is to keep up with or outpace inflation so when retirement hits the value of each dollar you have saved isn’t diminished. This means having aggressive retirement savings goals when you are young and continuing regular savings habits into the height of your career. If you have debt you are worried about, read Brian’s blog about the advantages of saving at the same time as paying off debt.
Our BOLT IRAs offer a wide array of investment options including institutional class mutual funds that have lower expense ratios, creating more opportunity for your account to grow. Having a team of advisers means you have more support and more resources as you save for retirement and work towards all your financial goals. Let us know how we can help!
[Michael D Manjarrez: updated with 2021 limits 01/14/2021]