When we think about saving for retirement to have income in the future and greater financial security, most of us know that IRAs can be very helpful. You might even know that there are two main kinds of IRAs -- traditional IRAs and Roth IRAs -- but you might not know which is better for you. Here's what you need to know to decide.
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IRAs can build retirement security
First, a review of just what IRAs are and how they work is in order.
With a traditional IRA, you contribute pre-tax money, reducing your taxable income for the year, and thereby reducing your taxes, too. (Taxable income of $70,000 and a $5,000 contribution? You'll only report $65,000 in taxable income for the year.) The money grows in your account and is taxed at your ordinary income tax rate when you withdraw it in retirement.
With a Roth IRA, you contribute post-tax money that doesn't reduce your taxable income at all in the contribution year. (Taxable income of $70,000 and a $5,000 contribution? Your taxable income remains $70,000 for the year.) Here's why the Roth IRA is a big deal, though: If you follow the rules, your money grows in the account until you withdraw it in retirement -- tax free.
Contribution limits are adjusted over time to keep up with changes in the cost of living. The limits for both the 2016 and 2017 tax years are the same: $5,500. There's also an extra $1,000 "catch-up" contribution permitted for those age 50 or older, letting those folks sock away as much as $6,500 for the year. Note, too, that the limit applies to one or more IRAs, together -- not to each of any IRA you might have. That means you could spread a $5,500 contribution for 2017 across both a traditional and a Roth IRA.
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Benefits of traditional IRAs
One of the benefits of saving for retirement with a traditional IRA is this: Remember that your money in the account is only taxed when you withdraw it, and that it's taxed then at your ordinary income tax rate? Well, many people are in lower tax brackets in retirement, because of having less income. Imagine that you are in the 25% tax bracket while you're employed, and you contribute $5,000 to your traditional IRA. If you'd not made the contribution or if you'd contributed it to a Roth IRA, it would remain as part of your taxable income, and you'd pay $1,250 on it. You save that $1,250, though, by contributing it to a traditional IRA. If in retirement you're in the 15% tax bracket and you withdraw $5,000 from the account, you'll only hand over 15%, or $750, of it -- and will have avoided paying $500 in taxes.
So key benefits of traditional IRAs are that they can shrink your tax bill -- both now and later. Note, though, that if your income is higher in retirement and you're in a higher tax bracket, you'll be paying more on your withdrawals than you would have when you contributed the money.
One drawback, or headache, related to traditional IRAs is that, unlike Roth IRAs, they feature required minimum distributions (RMDs), which you must take once you turn 70 1/2 -- otherwise you'll face stiff penalties. There's a formula for determining your RMD each year and your IRA administrator will often let you know how much you must withdraw.
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Benefits of Roth IRAs
The biggest benefit of the Roth IRA is that all the money in the account can end up available to you in retirement free of taxes. To fully appreciate that, check out how an annual $5,000 contribution would grow over time at 8%:
|
Growing at 8% For: |
$5,000 Invested Annually |
|---|---|
|
15 years |
$146,621 |
|
20 years |
$247,115 |
|
25 years |
$394,772 |
|
30 years |
$611,729 |
Calculations by author.
If you end up with $400,000 in your account and withdraw all of it in retirement tax free, you'd avoid paying a whopping $100,000 on it if you were in the 25% tax bracket or $60,000 if you were in the 15% bracket. The savings alone is enough to live on for a year or more in retirement.
Another benefit of Roth IRAs is that they don't feature RMDs. If you inherit any kind of IRA, though, you'll likely face RMDs.
Finally, Roth IRAs are more generous should you want to withdraw money early (i.e. before you turn 59 1/2). Traditional IRAs will generally sock such withdrawals with a 10% penalty and will tax them at your income tax rate, but Roth IRAs will let you withdraw sums you contributed (not their earnings) without the penalty or the taxes. There are a few circumstances in which you can take "qualified distributions" from either IRA without penalty. These include first-time home purchases, medical expenses, and college expenses.
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Which IRA will improve your financial future the most?
When deciding between the two kinds of IRAs, consider their features (such as how their tax benefits are structured and whether they have RMDs) and which ones would serve you best. If you're a high earner, you'll also want to look into how much you can contribute to either IRA, as one might permit greater contributions. (Those with high incomes may not be able to make the maximum tax-advantaged contributions.) Then consider your current and future expected tax rates and estimate how much each IRA can save you.
You can learn more about opening an IRA (or switching providers, as some offer better terms and lower fees than others), visit our IRA Center.
