What is an IRA?
You need an IRA. To be clear, this is not Ira, the aunt you see at your dad’s side of the family’s Christmas. Having an IRA (the non-aunt kind) is much cooler than the socks and fudge you might be getting once a year that you hope to re-gift.
IRA stands for individual retirement account (sexy, right?), and there are two primary types of IRAs: a traditional and a Roth IRA. They are pretty similar in some areas, but differ in others. You can be smart by making your decision between the two based on factors like your age, income, and tax consequences now and later in life.
We are going to discuss both the Roth and the Traditional IRA in detail, but I’d like to do the blogging equivalent of buying you a drink first and go into why IRAs are important and how they can help you in both the short and long runs.
Why do you need an IRA?
An IRA is an investment that can make you the cool-kid in retirement. If you choose to contribute to a Roth IRA, you won’t get taxed in retirement when it comes time to take money out of the account. If you pick the traditional IRA, you’ll get a tax benefit now because you can deduct your contribution from your taxable income, whoop whoop!
I love IRAs because just about anyone can benefit from them both now and in the future. It doesn’t matter whether you have a retirement plan with your employer or even whether you have an employer or not, you can have an IRA. The tax effects work a little bit differently, but you can still ensure your 65-year-old Boca-loving-self will have a bigger chunk of change than if you didn’t have one.
Alright, now we’re going to get to the skinny on Traditional v. Roth so that you can get to figuring out which one is best for you!
The Traditional IRA
An IRA is like a side-hustle, but for your retirement saving. Essentially, Uncle Sam lets you put $5,500 into an a savings (retirement savings) account and use that contribution as a tax-deduction. That’s right, you get to write off up to $5,500 of your taxable income and reap the benefit of lower taxes now while setting aside that money for later.
During the 2015 taxable year, for me, this amounted to saving almost $1,500 in taxes by contributing $5,500 to a Traditional IRA. So while I have $5,500 less in my checking/savings account, by putting it in an IRA I got $1,500 back. It is just too much money for me to pass up!
Also, your earnings on the money that you put into a Traditional IRA get to grow tax-deferred. This means your money goes to work for you and gets bigger, each year, until you retire and actually draw money out of the account.
Lastly, your ability to contribute to an IRA is not limited by your income. No matter how much you make, you’ve always got your $5,500 contribution that you can make. This is super good news if you’re like me and plan to be making boatloads more money in the future (a girl can dream, right?)
The finer, slightly less rosy print:
The $5,500 (or however much you contribute, up to $5,500) tax deduction starts to get phased out once you make a certain amount of money–between $61,000 and $71,000 if you’re single, $98,000 to $118,000 if you’re married and filing jointly and participate in an employer-sponsored plan (lookin’ at you, 401k). But there are definitely still benefits to contributing to an IRA, so don’t get your panties in too much of a bunch.
Like wine, a Traditional IRA is best left to age without you dipping into it…If you take money out of your IRA before age 59 and 1/2, you will have to face the tax music (i.e. pay ordinary income tax) and on top of that, get hit with a 10% penalty on that money. This is no bueno, so try to just let it sit for your slightly older self to enjoy, penalty-free, a little later on.
On to the next: the Roth IRA
A Roth IRA is similar to a traditional IRA. You still get to stash away up to $5,500 per year and the great thing is that you won’t be taxed on the withdrawal of contributions, or qualified distributions from that account no matter what age you are.
The other major benefit is that when it does come time to take money from your Roth IRA, you don’t have to pay taxes on the earnings (dividends and returns on your investments), provided you aren’t withdrawing them before age 59 and 1/2. So if you can hold off until then, you can avoid paying any penalties or taxes.
Basically, a Roth IRA is a great option if you want to reduce your taxes in retirement. Retired you will be so happy with current you that you set aside that $5,500 year in and year out and allow it to grow, tax-free, so I would give this investment option some serious thought.
The tradeoffs (because there always will be some):
You don’t get to deduct the money that you put into this account from your taxable income. That’s really the biggest tradeoff, because it feels like you earned $5,500 less after putting it into a Roth IRA, but the IRS is all like, “idc, you’ve still got to pony up the money like you spent it on a vacation to Europe and glamour pics for your dog”.
The other difference between a Roth IRA and a Traditional IRA is that eligibility and contribution amounts can be limited by how much you make. If you’d like to know in detail what those limitations are, check out this helpful page by everyone’s favorite 3-letter government agency, the IRS. The short story is that if you make $184,000 to $194,000 and above, you will get phased out of the amount of money you’re able to contribute to a Roth IRA. I know this is not a concern for most of us, but for all you six-figure people out there, you might need to look to a Traditional IRA instead.
Beyond what we’ve already discussed, there are a few exceptions to early withdrawals like it’s your first-time buying a home and you want to use the money for that or you have medical costs you need to cover, but for the most part you can kind of assume that early withdrawal of earnings will be taxed.
Alright, now that you know about Traditional and Roth IRAs, you can go shopping!
There are tons of great, low-cost investment options out there for both Roth and Traditional IRAs. I’ve got a traditional one with TD Ameritrade, but you aren’t going to go wrong if you pick anyone on this list to be on your IRA team:
- E*TRADE – They’ve got a $0 account minimum and access to every investment resource you could ever need. Voted best overall by The Simple Dollar.
- Scottrade – Great for beginners, great customer service no matter the amount of money in your account ($0 minimum as well). Voted best overall for Roth IRAs by Good Financial Cents.
- Charles Schwab – They have many no-transaction-fee mutual fund options, making your investment choices low-cost and easy to change. They have a $1,000 minimum account balance, but are a long-trusted invesment mangager actual brick-and-mortar branches if that’s your thing. Nerd Wallet gives them “Best Overall” citing “large fund selection, high-quality customer service, and reasonable account minimums and fees”.
- Betterment – They’ve made a big spash in the investment community lately. They make it very easy to open up a retirement account (5 minutes, that’s all!) and let you be a hands-off investor while they grow your money for you. Investor Junkie gives it 5 stars and have heard firsthand from people who use it how great they think it is.
- Wealthfront – The best of modern investment technology gives you a sophisticated, diversified, and low-cost investment. They charge no fee to manage your money up to $15,000, and after that it’s a flat 0.25% fee per year. Cash Cow Couple speak very highly of Wealthfront calling it “automated, low-cost investing”.
We established today that there are two primary types of IRAs (individual retirement accounts). The one you choose depends largely on 3 factors that you want to consider so that you can optimize your retirement saving:
- Tax consequences now and in retirement
- contributions may be tax deductible
- earnings grow tax-deferred
- your eligibility to contribute is not limited by income
- withdrawals of contributions and earnings are taxed at your rate in reti
- no contributions are allowed after age 70 and 1/2
- there are required minimum distributions starting at age 70 and 1/2
- no taxes on withdrawals of contributions
- no tax on earnings*
- no required minimum distributions
- no age limit to open a Roth IRA or contribute to it
- eligibility and contribution amounts can be limited by your income
- contributions are not tax-deductible
*As long as you’ve held the account 5 years, you’re age 59 and 1/2 or older, or an exception applies
One last note to tie the whole thing together: the IRS says you can contribute $5,500 total to your Roth/Traditional IRAs. So, between the two of them you are limited to $5,500 in contributions, not $5,500 to each.
That’s all I’ve got! I hope this information helps you understand why it’s important to save for retirement and how having an IRA can give your saving an extra boost. Depending on the IRA you choose, it can also ease your tax burden in retirement or your tax burden each year, so that knowledge alone is worth a lot, too.
If you’ve got any questions…please comment below or email me at firstname.lastname@example.org. I look forward to hearing from you!
Spreadin’ the IRA love,
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