Most people have some form of 401k, pension, combination of both offered by their employer, but if you don’t or you just want to save more on your own (recommended), what can you do? An IRA is the right place to start.
There’s a Traditional IRA and a Roth IRA. Let’s start with what they have in common, both will:
- allow you to grow your contributions tax free (increases in your accounts due to growth are tax free).
- allow you to contribute up to $5,000/year ($6,000/year if you’re over 50).
- make you pay a 10% penalty if you withdraw funds early; before you turn 50 ½ years old.
Here’s where they differ:
- Taxes on Your Contributions – if you qualify (check here), your traditional IRA contribution is deductible in the year you contribute. Roth IRA contributions are not. You pay full income tax on Roth contributions in the year you contribute them.
- Taxes on Withdrawals – In a traditional IRA, you pay taxes on the contribution part of your withdrawals when you withdrawal it (growth is not taxed remember). On a Roth IRA, you pay no taxes on the withdrawals because they were taxed when you contributed the funds years ago.
- Mandatory Withdrawals – With a traditional IRA you must take distributions by April 1st of the year you turn 70 ½, because the IRS wants to collect taxes on the contributed money and it can’t do that until you take a distributions, therefore you are forced to take a distribution. There are no minimum distributions with a Roth because you’ve already paid taxes.
Which one should you have?
- Tax bracket considerations – if you’re current tax bracket is higher than your predicted tax bracket at retirement, get a traditional IRA. Many people expect to be in a lower tax bracket in retirement because they would earn less. If you think you’ll be in a higher bracket in retirement, consider a Roth.
- Flexibility – With a Traditional IRA, you have to take distributions (take some of your money out) at age 70 ½. You cannot decide to leave the money there if don’t need it until you’re older than 70 ½ because the only way the government gets its taxes is by making you take distributions. A Roth allows you to time the distributions to your needs or pass the money tax free onto your heirs.
Conclusion: if you think you will be wealthier when you’re older than you are now, i.e. you will be in a higher income tax bracket, may not need the money right away on your 70 ½ birthday, or you want to bequeath the money to your heirs tax-free, you should go with a Roth IRA.
If you think you will live on a lower income in your retirement than you are now, go with a traditional IRA so you pay your anticipated lower future tax rate on the money.
If you just can’t decide, you can have a combination Roth/Traditional, but your total yearly contribution will still be up to $5,000.
IN any case, just start saving!