Answer: Individual Retirement Account
There are 7 types of IRAs:
- Traditional IRA
- Roth IRA
- SEP IRA
- Non Deductible IRA
- Spousal IRA
- Simple IRA
- Self-Directed IRA
This article will focus on the 2 most popular IRAs: TRADITIONAL & ROTH and will help explain why they are essential tools for retirement planning.
WHAT IS THE DIFFERENCE BETWEEN A TRADITIONAL IRA & A ROTH IRA?
Answer: The difference is essentially when you receive a tax break (and contribution rules)
TRADITIONAL IRA (NOW) | ROTH IRA (LATER)
TRADITIONAL IRA
PROS:
- Pre-Tax Contributions. Any contributions you make to a Traditional IRA lowers your current year’s taxable income.
If you are on the cusp between tax brackets and the $6,000 (the max contribution limit for 2020 for those under 50) can lower your tax tier than this could potentially save you quite a bit on your income tax.
- No Cap Income Restrictions. Regardless of how high your income, you can contribute to a Traditional IRA.
CONS:
- Withdrawals Are Taxed | This is a pretty significant con since your income at retirement should be greater than your current income (assuming you’ve been saving for decades to retirement and the market hasn’t collapsed).
- Mandatory Withdrawals (RMD)| As soon as you reach 70 1/2, you can no longer contribute to a Traditional IRA and must make minimum withdrawals annually.
- Early Withdrawal Penalties | If you are younger than 59 1/2 and withdraw from your Traditional IRA, there will be a 10% penalty. Additionally you will have to pay income tax on the total of the withdrawn amount.
*There are instances where this penalty is waived. Example: buying your 1st home
ROTH IRA
PROS:
- Tax-Free Withdrawals | After you turn 59 1/2, you may start to withdraw money from your Roth IRA tax-free!
After decades of investing in a Roth IRA, investments are compounded exponentially. This exponential growth may potentially result in a vast annual income.
Here is a hypothetical example to help clarify the significance of the Tax-Free Withdrawal benefit:
Person A (Single) makes an “earned income” of $100,000 annually. This puts Person A in the 24% tax rate tier for this year (2020). $24,000 of their earned income will be paid to the IRS. Person A’s earned income actual take-home amounts to $76,000.
On the other hand:
Person B (over age 59 1/2) makes an annual withdrawal of $100,000 from their Roth IRA. Since the Roth IRA has a Tax-Free Withdrawal perk, Person B will not have to pay taxes on the $100,000 they have withdrawn. That’s an annual savings of $24,000!
*The IRS classifies “earned income” separately from passive income. (Example: rental income is not classified as “earned income”)
CONS:
- Income Cap Limits | If your earned income is over that year’s set threshold, you cannot contribute to a Roth IRA.
*There is a back-door solution. Hypothetically, if one’s income is exceeds the cap, one may technically contribute to a Traditional IRA that year and then transfer those monies into a Roth IRA.
WHAT TYPE OF IRA SHOULD YOU INVEST IN?
Answer: It depends
- If you have more than 30 years until retirement – Roth IRA
This assumes your income rate will be greater at retirement than currently is
- If your income at retirement will be less than your current income – Traditional IRA
- If your taxable income can be lessened enough to change your tax bracket to a significantly lower tax rate – Traditional IRA
I strongly encourage you to begin investing in an IRA today. Each day you hold off on doing so is another day that money sitting stagnately in the bank could be compounding and making you more tax-free money! The opportunity cost of not investing in an IRA is too great.
*If you already have a 401K (I hope it’s a Roth 401k if you still have 30+ years until retirement) you may still reap the benefits of investing in an IRA. Maxing out both your 401k and IRA each year will expedite your retirement savings exponentially!