There's no such thing as a one-size-fits-all retirement plan. Because we all have specific, individual needs, what might work for one person might cause another to come up short financially when they're older. It's surprising, then, to learn that most Americans believe all IRAs are exactly the same. In a recent TIAA survey, 56% of respondents stated that an IRA is an IRA -- i.e., there's no difference from one type of account to another. Not only that, but only 33% of Americans have an IRA to begin with.
While it's true that all IRAs have certain universal features, there can be big differences from one IRA to the next. Knowing these differences can help you identify the right long-term savings solution for you.
Types of IRAs
Contrary to what so many Americans believe, IRAs come in a few different varieties. First there's the traditional IRA, which lets you save up to $5,500 a year (or $6,500 if you're aged 50 or older) and deduct the contributions from your taxable income. Your withdrawals, however, will be taxed during retirement, which can be a pretty significant drawback.
Roth IRAs have the same annual limits as traditional IRAs, but the tax break comes later: Roth IRA contributions are not deductible, but withdrawals from a Roth are tax-free.
While you'll be penalized for withdrawing funds from a traditional IRA before reaching age 59-1/2, you can remove money from a Roth at any time as long as you're only touching your principal (not your gains). Another major difference between the two is that traditional IRAs impose required minimum distributions that you'll need to start taking once you turn 70-1/2. The exact amount you'll need to withdraw will depend on your account balance and life expectancy at the time, but you should know that if you don't take your required distributions, you'll be penalized to the tune of 50% of the amount you failed to withdraw.
So why wouldn't you want to withdraw funds from your IRA once you reach 70-1/2? For one thing, you might still be working, or you may have a different source of income to tap. Remember: Traditional IRA withdrawals are taxed in retirement, so that extra income could result in higher taxes than you want to pay. Furthermore, once you remove money from your IRA, it can no longer benefit from tax-free growth. While you can take that money and reinvest it in a traditional brokerage account, you'll pay taxes on any gains you realize along the way.
Because Roth IRAs don't impose required minimum distributions, you're free to let your money sit and grow indefinitely. However, not everyone can contribute to a Roth. If you earn more than $133,000 this year as a single tax filer or more than $196,000 as a married couple filing jointly, then you won't be eligible for a Roth.
While the traditional and Roth versions of the IRA are the most popular, there are also two other types of IRA you might consider if you own a small business or are self-employed: the SEP IRA and the SIMPLE IRA. Both come with higher annual contribution limits than traditional and Roth IRAs, so it pays to see whether either option might work for you.
Investing your IRA
Just as the type of IRA you choose will make a difference in your overall retirement picture, so too will the individual investments you select. Once you fund your IRA, you get the choice to invest your money as you see fit. If your tolerance for risk is fairly high and you start early enough, then you should consider investing in individual stocks. Stocks carry a higher risk than bonds, but they've historically offered greater returns. Better yet, if you're willing to invest in stocks, you might consider those that pay dividends. Then you stand a good chance of growing your capital while generating a steady income stream in retirement.
If you're the risk-averse type but you still want relatively high growth, then your next best bet is to look into index funds. Because index funds simply seek to track the performance of broad stock-market indexes, you get the benefit of built-in diversification without the added risk and legwork of choosing individual companies to invest in. And since index funds are passively managed, their fees tend to be fairly low. (Actively managed funds, by contrast, typically charge much higher fees that can eat away at your returns.) If you're new to investing, take a look at the Vanguard S&P 500 ETF (NYSEMKT:VOO), which boasts a strong performance history at a minimal cost to you as an investor.
Finally, if you really want to take the guesswork out of investing your retirement savings, you could opt for a target date fund. Target date funds automatically balance (and rebalance) your investments based on your anticipated retirement date so that as time goes on, your exposure to risk declines. If you'd rather not take an active role in managing your investments, target date funds might a good choice.
The type of IRA you open, coupled with the investments you choose, can have a huge impact on your ultimate retirement savings balance. But whether you opt for a traditional IRA, a Roth, a stock-heavy portfolio, or a series of bond funds, remember this: The sooner you start funding that account, the more opportunity you'll have for your money to grow. You can visit our IRA center to learn about more about the options available to you.