When it comes to saving for retirement, you have lots of choices. Most people know about 401(k) plans through their employers. However, in the current culture, that’s not always an option for people. More and more often, companies are opting to hire contractors to work for them as opposed to full time employees, which means a 401(k) may not be as attractive a package without the employer match. So what are the other options out there for people?
The traditional Individual Retirement Account (IRA) and the Roth IRA are both popular alternatives for their simplicity and ease of investing. But what is an IRA and which of the two options is best for you?
What is an IRA?
An IRA is short for an Individual Retirement Account, and there are quite a few different kinds. In addition to the traditional and Roth IRA accounts, Simple and SEP IRAs are also available, however those are more specific to people who are self-employed, including small business owners. However, the former two are available to anyone who makes a taxable amount of money every year. Both accounts are subject to penalties if you make early withdrawals before the age of 59½.
What’s the Difference Between a Traditional IRA and a Roth IRA?
The main differences in these accounts has to do with when the money that is deposited gets taxed.
Traditional IRA deposits can typically be written off on your taxes, up to $5,500 if you’re under 50 years old. If you’re over 50, you can deposit an extra $1,000 a year, as a “catch-up” contribution. This is so that you’re able to come closer to your financial goals when it’s time to retire, even if you started investing later on in life. However, when you withdraw money in retirement, it will be subject to whatever the tax rate is at that time. There’s no way to lock in what the tax rate was when you opened the account.
Roth IRAs have the same contribution limits but are not tax-deductible. This means you’ll have to claim the contributions as income on your taxes, even though it was invested. However, when you make withdrawals later on in life, those can be taken out tax-free.
What Are the Differences of a Traditional IRA?
A traditional IRA is usually a good selection when people need a basic retirement vehicle, and would like to get a bit of a tax break as well. However, you may not always get the full $5,500 in deductions. The traditional IRA has a few caveats associated with it. You’ll need to check with your tax professional to see how much you’ll be able to contribute, taking your other investment options, like a 401(k), into account. You can also only make contributions if you’re within a certain age range. For example, it’s likely that if you’re over the age of 70½, you won’t be able to contribute to your traditional IRA anymore. This is something else you’ll want to talk to your tax professional about.
What Are the Differences of a Roth IRA?
Now that you know the nuances of the traditional IRA, you can probably guess some of the characteristics that make the Roth IRA different. Like with the traditional IRA, you maybe be subject to limitations based on your income, but you’ll want to check with your tax professional about that first. However, a major difference is that you can continue to contribute at any age. This means when you’re forced to take your Required Minimum Distributions with a traditional IRA or other retirement investment account, if you don’t need that money to supplement your income, you can reinvest it right back into your Roth IRA account. Of course, you’ll want to check with your tax professional or financial planner before choosing to go this route.
A potential drawback to the Roth is the five-year-minimum holding requirement. This means that any earnings you make must stay in the account for at least five years before you can attempt to withdraw them.
Are There Any Other Pros to IRAs?
In addition to providing you with an income supplement in retirement, there are other ways an IRA can benefit you, even before you choose to punch your last timecard. If you want to take out a sum of money early, the IRS allows you to do that for a few things. The first is for medical expenses. NerdWallet explains, “There are several health-care and health-related situations where the IRS will waive the 10% early withdrawal requirement. They include withdrawing money to pay for unreimbursed medical expenses, health insurance premiums after 12 weeks of unemployment and if you become disabled before age 59½.”
A few other options to have the 10% early withdrawal penalty waived are if you use the money to pay for higher education for you, your spouse, kids or grandkids. You can also take out up to $10,000 if you need some more cash to help buy your first home.
Additionally, if you inherited an IRA, and have not rolled it over into your own IRA account, then you can make withdrawals tax-free.
Before making any kind of financial decision, you’ll want to sit down with a financial planner and/or your tax professional. While a Roth IRA may sound attractive for many reasons, your current financial situation may benefit more from receiving the potential tax write-off from your traditional IRA contributions. Conversely, If you don’t necessarily need the tax write-off right now, and would rather take the tax break later on, then a Roth might be the way to go — but will you fall within the income requirements for one? If you already have a fairly robust investment portfolio and want an IRA as a type of safety net, then Roth may be a good option since you can continue investing past the age of 70½.
Make a list of pros and cons about how each type of account will benefit you in retirement, especially as you prepare for the next act in your life. Remember that your choices will affect the type of life you may be able to live down the road.