Investing is far from simple, especially when you start looking at all your options and trying to determine what is right for you. When it comes to your retirement, Individual Retirement Accounts, or IRAs, are the most widely-used investment vehicles. They are retirement accounts that are separate from your employment, which greatly simplifies things. IRAs can be invested in just about anything but life insurance and collectibles, so there aren’t as many restrictions as 401(k) plans which limit you to a preselected group of investment choices.
IRAs seem like a simple, straight-forward investment option, right? Unfortunately, the financial world does not make things that easy. IRAs are available in two main types: traditional and Roth.
Benefits Of Investing In a Traditional IRA
Before 1997 rolled around, investors had only one option when it came to IRAs: the traditional IRA. Here are the basics: It is a tax-deferred retirement account, so it is funded with pre-tax money and the taxes are paid when money is taken out of the account in retirement. The great thing about that is that you have more money available to invest if you don’t have to pay taxes out of it first. Also, you could be in a lower tax bracket in retirement and may pay less in taxes than you would have if you had paid them upfront at the time of investment.
Benefits Of Investing In a Roth IRA
The Roth IRA was created in 1997 when Senator William Roth sponsored the Taxpayer Relief Act. There are a few key factors that distinguish a Roth IRA from a traditional one. The primary difference is the tax treatment. Whereas traditional IRAs are tax-deferred, with a Roth you pay all taxes up front (your contributions are made with after-tax dollars). The perk is that receive tax-free withdrawals in retirement (after the age of 59-½). When you decide to withdraw the money, you don’t have to pay taxes on any of the growth.
Another significant difference is that there are no required minimum distributions. You can leave your money in the account to grow forever, instead of being required to start taking withdrawals (and stop contributions) at age 70 ½ as you would with a traditional IRA account. This allows you to use a Roth IRA as an estate planning tool to provide tax-free income for grandchildren and future generations.
One often overlooked benefit of Roth IRAs is that you can withdraw your contributions (not your earnings) at any time and for any reason. For example, let’s say you invested $2000 in a Roth IRA when you were 25. Fast-forward ten years and your money has grown to $4000. If you needed some money for a down payment on a house or to pay down some debt, you have the option to withdraw the $2000 penalty-free. Many people are drawn to this kind of flexibility.
The one restriction is that there are income limitations to qualify for a Roth IRA. For 2017, singles making over $133,000 cannot contribute to a Roth and the amount they can contribute begins phasing out after $118,000 of earnings. The phase-out period for married tax filers is $186,000-$196,000. (1) However, anyone can convert a traditional IRA into a Roth through a “backdoor conversion.”
Which IRA Is Right For You?
Because of the different tax treatments, a Roth IRA is almost always better for younger people who have more time to save and want to take advantage of compound interest. If you are closer to retirement and will need the money early in your retirement, you may be better off with a traditional IRA. Many people choose a Roth regardless of their age so that they won’t be required to take distributions and they can leave the money to their families. If you make too much money to be eligible for a tax deduction for a traditional IRA you are better off with a Roth, though you will have to do a “backdoor” conversion to open one.
If you are rolling over an old 401(k) to open your IRA, the type of account you choose will have considerable tax implications. You won’t have to pay any taxes to roll a traditional 401(k) into a traditional IRA, but to roll it into a Roth will require you to pay taxes on the entire amount. If you don’t have extra money to pay the taxes, you may be limited to a traditional IRA.
How I Can Help
The type of IRA that is best for you depends on your personal situation and preferences. When making important financial decisions like this, it always helps to talk to an experienced professional who can help you understand your options and the implications of different choices. If you are considering investing in an IRA, please contact me today by calling my office at 770.249.7424 or emailing me at firstname.lastname@example.org. I can help you choose the best IRA to fund your specific retirement goals.