Retirement is so far away. It is easy to focus on more immediate concerns like bills, saving for a house, or buying a car. However, while retirement may be decades away, it will also be the second longest period of your life where you won’t work. The longest was obviously your childhood. It can be tempting to just plan on working well into older age, there will come a point where you simply cannot work anymore due to health issues or you just don’t want to work anymore.
This is where retirement savings comes in. You set that money aside so that you don’t have to work later. If you save a lot and invest, you may even be able to retire early by reaching financial independence. There are numerous examples of people who really put their mind to it and created a life where they can do whatever they want, even work if and when they choose to do so.
Whether or not retiring early is your goal, saving is key. The higher your savings rate, the better chance you have of a good quality of life post-retirement. That plus investing is an easy formula to wealth.
“What is an IRA?” I hear you thinking this question. “I’m on board with saving and investing, but how do I do that?” Well IRA stands for individual retirement account. This is a non-employer-based retirement savings vehicle. You may have a 401(k) in your garage or a deferred compensation plan or some other defined benefit plan from your job. If you have any of these options, I recommend you investigate them. Many employers offer a match, which is free money, but even without that, it is worthwhile to take advantage of these kinds of plans if the terms are good.
An IRA is a retirement savings plan that you set up for yourself. You’re buying regular investments such as mutual funds or ETFs (exchange-traded funds), but there is a shield around them. These investments are earmarked for retirement and you must follow certain rules in exchange for the benefits. There are two primary kinds of IRAs.
A traditional IRA is a tax-deferred account. The money you are investing will not be taxed now with the rest of your income, but instead, will be taxed later. The income taxes are deferred until you begin making withdrawals. When you do your taxes, you subtract the money you invested from your income before your income tax bill is calculated. This lowers the amount of tax you owe at the end of the year.
How is this beneficial to you if you’re going to pay the income taxes anyway, just at a later point in time? The assumption is that once you retire, your income will be lower and you will be in a lower tax bracket. Rather than paying taxes in your current, higher tax bracket, you pay at a lower tax rate and lock in part of the savings. However, funds in a traditional IRA cannot be withdrawn without penalty until you reach retirement age, which is 59 1/2. Yes, and a half.
- Being able to delay taxation and reduce your tax bill in the present.
- Hopefully paying a lower income tax rate on the deferred income in retirement.
- If you try to withdraw any of the money, whether contributions you made or earnings, before retirement age, you will have to pay a 10 percent penalty on top of the income tax due.
- You can wait to withdraw your money, but when you reach age 70 1/2 you must begin taking distributions whether you need the income or not.
A Roth IRA is based on a post-tax structure and is eventually a tax-free account. There is no immediate tax benefit to investing in one of these types of accounts. The money you are investing is post-tax, meaning you are paying income taxes on it now. The benefit to this is that you can withdraw your contributions at any time for any reason. No additional taxes are due.
The earnings follow different rules. You can only withdraw earnings before retirement age for specific reasons, called qualified distributions, such as buying a first home. If you withdraw earnings for any other reason, known as a non-qualified distribution, you face the same 10% penalty for early withdrawal as for a traditional IRA in addition to income taxes on those earnings. The primary benefit to a Roth IRA is that once you reach retirement age, 59 1/2 again, all your distributions, including from earnings, are tax-free.
- You can withdraw contributions at any time without tax or penalty, making them available for emergency use or income in early retirement.
- Once you reach retirement age, both contributions and earnings can be withdrawn tax-free.
- You can access earnings early for qualified purposes without penalty, though only if five tax years have passed since the Roth IRA was first opened.
- There is no required distribution age, so the account can be preserved for posterity.
- There is no immediate tax benefit. Your contributions come from your after-tax income so there are no current income tax savings.
You can convert a traditional IRA to a Roth IRA, but there are costs to doing this. You must pay the income taxes that you deferred earlier and you cannot withdraw these conversion contributions for five years without incurring a penalty. Annual contributions directly to the Roth IRA will follow the regular rules.
“You will need to decide which is best for your financial plan based on your unique circumstances.”
This is a very basic overview of traditional and Roth IRAs. This is not investment advice and I am not advocating one type of IRA over the other. They each have their strengths and weaknesses. We will talk in more detail about these later, but I want you to start thinking about taking more direct control over your retirement savings. There is one annual limit for investing in IRAs. This means, for the current year, $5,500 is the total limit for both traditional and Roth IRAs instead of for each. However, this is in addition to the amount you can invest in employer-sponsored plans. So you are expanding your capacity to save for retirement. You will need to decide which is best for your financial plan based on your unique circumstances.
But wait, what am I doing?
I also mentioned my savings and that I am restarting my contributions. I choose to invest in a Roth IRA because I would rather pay taxes while I am still earning. My future plans involve a lot of travel and not working. I am also working toward early retirement and Roth IRA contributions can be an important source of income during those years before I reach the regular retirement age. This is my choice and it may not be right for you. I stopped contributing for several years due to financial difficulties, but I am back to a position where I can start investing again. I have lost time and possible earnings, but at least I am getting back to it. It’s important to not beat ourselves up for difficult situations. We can learn from them and move on with our lives.
Have you thought about investing in an IRA? Do you invest in an IRA? Which did you choose and why?