Traditional IRA vs Roth IRA
What if you don't have a 401K (403b, a “Simple IRA” or a or a SOLO 401K) at work? Or maybe you don't like the available plan options. There are still tax-advantaged ways you can save for retirement. Primarily we are talking about the Traditional IRA and the Roth IRA.
With a Traditional IRA you can put away up to up to $5,500, or $6,600 if you 50 years or older. The contributions are tax deductible just like a 401K and when you retire, you will pay tax on the funds withdrawn; however, If you or your spouse are covered by a 401K at work – even if you do not utilize it – your contribution could be limited depending on your income. (please visit the IRS ). In addition, if you have a 401K type plan at work, and you contribute to it, the tax deduction for your IRA is reduced by the amount you put into the 401K. So if you put $5,000 into your 401K, you only get a $500 tax-deductible contribution to an IRA. For many the 401K, is going to be the best opportunity to save especially if your work has a matching program.
How does a Traditional IRA work? It’s really quite simple. You open an IRA account with anyone of a number mutual fund or brokerage firms, (be certain its an IRA account) and start saving! You can find IRAs that allow you to invest in almost any imaginable financial product including CDs, stocks, bonds, mutual funds and target date funds. Where should you invest your monies – we will cover all that later. Promise!
Like anything else in life, there are rules. You can start withdrawing money from your IRA as early as age 59½; however, withdrawals made before 59½ are subject to a penalty. You must start making required withdrawals by age 70½. Also, if you don't take your required minimum distributions once you reach 70½ the IRS will slap you with a tax that is equal to 50% of what you should have taken. Ouch! For a complete overview of the rules you should visit the IRS
The Advantage of a Roth IRA is that you save after tax income today and the money grows and is withdrawn tax-free at retirement! If you make less than $120,000 ($189,000 for couples) you can put up to $5,500 into a Roth IRA. If you make from $120,00 to $134,999 ($189,000 to $198,999 for couples) your maximum contribution is reduced based on an IRS formula. After this income level you are technically ineligible to participate. – We will investigate this further!
Clearly the ability to invest money now, have it grow for years and then withdraw it tax-free later at retirement is a really big deal. It means you can put away just $458 a month of after tax income – that's $220,000 over 40 years - and earn 6%, at retirement you get to enjoy over $900,000 of tax free money! Also account holders are never forced to withdraw money and if you continue to work into retirement you can continue to put money away. If you don't use the money you can leave the account to your heirs so a Roth can be used for estate planning. Funds can be invested in almost any imaginable financial product. Really the only rules are that you must keep the account at least five years and wait until you are 59½ before you can withdraw funds tax and penalty free.
Really suffering from Roth envy but don't qualify – who would blame you? Well under certain circumstances you can get a Roth account even if you don't technically quality. Its called a “Backdoor Roth” and we will be covering that soon!