Though many seniors do experience a drop in living expenses once they retire, this doesn't always happen. In fact, some seniors actually wind up spending more in retirement than they did during their working years. It's for this reason that saving adequately is extremely crucial, and while you have several options available for socking away money, funding an IRA is a good way to establish a nest egg.
One major benefit of saving in an IRA is the tax-advantaged treatment it offers your money. If you contribute to a traditional IRA, not only will that money go in tax-free, but it'll grow tax-deferred until you're ready to take withdrawals. And while Roth IRA contributions are made with after-tax dollars, your money will grow completely tax-free, and you won't pay taxes on withdrawals in retirement. No matter which option you choose, avoiding taxes on your investment gains year after year can help you amass a sizable nest egg so that your IRA is worth a bundle by the time you need it.
Which IRA type is right for you?
Though both traditional and Roth IRAs offer a world of benefits, deciding which type to fund can be tricky. While you may be tempted to reap the up-front tax benefit of a traditional IRA, the downside is that your money won't be yours free and clear in retirement. A Roth IRA, meanwhile, won't help reduce your taxes initially, as you won't get a deduction for contributing. But when the time comes to take distributions, you won't owe a dime in taxes.
When choosing between these two IRA types, it pays to think about when you're most likely to need the maximum tax benefit. Is it during your working years, when your effective tax rate is presumably at its highest? Or is it during retirement, when you'll be living on a fixed income?
Keep in mind that while we know what tax rates look like today, there's no telling how they'll evolve over time -- so while you might think you're guaranteed to be in a lower tax bracket in retirement, that may not end up being the case. Funding a Roth IRA is therefore a means of protection from the unknowns of future tax rates.
How much will your IRA be worth?
Once you decide which type of IRA to open, the next step is making sure you amass enough savings to sustain yourself in retirement -- and we have a calculator that can show you how your savings stack up.
To use this tool, simply plug in your current age, desired retirement age, length of retirement, and annual contribution, and our calculator will let you know how much you stand to accumulate.
There are, however, some assumptions that will go into that calculation. First, you'll need to input your return on investment during the years you fund your account as well as in retirement. And that's where things can get a little complicated, because it's hard to know exactly how well your investments will perform.
That said, if you load up your portfolio with stocks during your working years, you can work off the assumption that your investments will generate an average yearly 7% return. This figure is actually a few points below the stock market's historical average.
As far as your average yearly return in retirement is concerned, you may want to adjust that percentage downward to allow for a partial shift toward safer investments, like bonds. Assuming your IRA houses a reasonably equal mix of stocks and bonds in retirement, you can work with a 5% or 6% average yearly return.
One final factor that'll play into your personal equation is your current and future tax bracket. As we discussed earlier, if you're decades away from retirement, predicting your eventual tax bracket can be challenging, but if you're aiming to mostly replace your current income in retirement, your tax bracket is likely to stay the same.
Once you input all the necessary data, you can get a sense of how much your IRA will be worth in retirement. If that number doesn't look good to you, then your best bet is to ramp up your savings and start maxing out your contributions.
Currently, savers under 50 can contribute up to $5,500 a year to an IRA. If you're 50 or older, you get a $1,000 catch-up that raises your limit to $6,500. Keep in mind that these limits might increase over time, as they've already gone up significantly since the IRA was first introduced. And if you make a point to hit whatever annual limit you're eligible for going forward, you stand a good chance of saving enough to meet your retirement goals.