Since I wrote about 401(k)s earlier this week, I figured I’d write about IRAs today. Not everyone has a job that provides an employer-sponsored retirement plan such as a 401(k). When this is the case, an IRA can often be a good alternative to start with to save for retirement.
Traditional IRA
An IRA (Individual Retirement Account) is a tax-advantaged retirement account that you setup for yourself at a financial institution. You can contribute money to the account, invest it and let it grow (hopefully), and then use the money to help fund your retirement upon reaching age 59 1/2. If you withdraw the money prior to age 59 1/2, then you’ll be hit with a penalty. When you withdraw the money later, it will be taxed at your ordinary income rate at that time. This type of IRA is commonly referred to as a “traditional IRA”.
In 2019, most people can contribute $6,000 to an IRA. Those who are 50-years-old or older are allowed an additional “catch-up” contribution of $1,000 for a total of $7,000 in 2019.
IRAs allow you to choose a much broader range of investment options, including some nontraditional options, than most employer-sponsored retirement plans. There are many different types of IRAs including traditional IRAs, Roth IRAs, SIMPLE IRAs, and SEP IRAs. For this article, I’m going to focus on traditional and Roth IRAs.
Roth IRA
Roth IRAs allow you to contribute after-tax money to the account, invest it and allow it to grow tax-free, and then withdraw the money tax-free. Unlike a traditional IRA, once you put money in a Roth you’ll never pay taxes on it again (under current law).
While this may sound great, there are a couple of questions that you can ask yourself to determine if contributing to a Roth is right for you: What is my tax bracket now? What do I think my tax bracket will be when I begin withdrawing money from the account? Do I think that tax rates will increase in the future or do I think that they will remain the same or decrease?
If you contribute money to the account now while you’re in a lower tax bracket and end up pulling out money later at a higher tax bracket, then you did the opposite of what you wanted to accomplish.
Income Limits
There are income limits to being able to deduct your contributions to a traditional IRA and to being able to contribute to a Roth IRA. You can find the IRA deduction limits here and the Roth IRA contribution limits here.
Those who “earn too much” according to IRS guidelines may not be able to make tax-deductible contributions to a traditional IRA. On the other hand, those who “earn too much” according to IRS guidelines may not make any contributions to a Roth at all.
Non-Deductible Contributions
I want to make this clear – you can always contribute money to a traditional IRA. No matter what. However, if your Modified Adjusted Gross Income (MAGI) is $74,000 or more (single) or $123,000 or more (married filing jointly), then you cannot deduct those contributions on your taxes.
If you earn above those amounts, and you would like to contribute to an IRA because it still holds tax advantages that a taxable brokerage account does not, then you would make “nondeductible” contributions. Your contributions would be made with after-tax money and invested and allowed to grow tax-deferred. However, when you withdraw the money from the account during retirement the gains on the money will be taxed, but the contributions that you have made throughout the years will not be.
Saving For Retirement
While the amount that you can contribute to an IRA is significantly lower than you can contribute to a 401(k), IRAs can still serve as great retirement savings accounts. Of course, I’m going to jump on my soapbox here and say that saving for retirement is something that everyone who isn’t retired yet needs to be doing.
It doesn’t matter if you’re near retirement and haven’t saved anything or if you only have $25 per month to save, creating behavioral change and habits will help you in the long run. If you’re a young professional who hasn’t started saving yet and think that using an IRA may be right for you, then even better – now is the best time to start. Actually, now is the best time to start no matter what stage of life or financial situation you’re in.
