When it comes to saving and investing for retirement, 401(k)s get a lot of attention because of how common they are. But IRAs are just as great a tool, and in some ways, they're better.
The difference between a traditional IRA and Roth IRA comes down to one thing: When you pay taxes. With a traditional IRA, you can possibly deduct your contributions from your taxable income, but you'll pay taxes when you take withdrawals in retirement.
With a Roth IRA, you contribute after-tax money and can take tax-free withdrawals in retirement. The ability to have your money grow tax-free is a blessing from the IRS, and it's arguably one of the best retirement savings hacks available.
Image source: Getty Images.
A supplemental source of retirement income
A great thing about a Roth IRA is that it operates like a brokerage account. Unlike a 401(k), where you're given set investment options, you can invest in any stock or exchange-traded fund (ETF) you want to in a Roth IRA. This allows you to truly invest in ways that align with your goals.
IRAs of both traditional and Roth varieties have a relatively low annual contribution limit -- $6,500 ($7,500 if you're 50 or older) -- so they likely won't be your primary source of retirement income. But they can serve as a great supplement, especially when you take advantage of them annually and let time work its magic.
Don't underestimate the power of compound earnings
Investors enjoy compound earnings when they take the money they make on investments and reinvest it so that it starts to earn returns on itself. Imagine you invest $1,000 annually and average 10% returns. In the first year, you'll earn $100. In year two, you'll earn $110, because the $100 in earnings from the first year will generate $10 in extra returns. In year three, you'll earn $121, and so on.
It's a tall task for most people to strictly save the amount they'll need for retirement, but it's very doable with compound earnings, consistency, and time. Below is how much you could accumulate if you invest $500 monthly and average 10% annual returns over certain spans:
| MONTHLY INVESTMENT | YEARS INVESTED | PERSONALLY INVESTED | TOTAL VALUE |
|---|---|---|---|
| $500 | 10 | $60,000 | $95,624 |
| $500 | 20 | $120,000 | $343,650 |
| $500 | 30 | $180,000 | $986,964 |
| $500 | 40 | $240,000 | $2.65 million |
| $500 | 50 | $300,000 | $6.98 million |
Data source: Author calculations.
It pays to use a Roth IRA
Using our above example, let's assume one person makes those investments in a brokerage account and one person makes them in a Roth IRA. Once the person using a brokerage account sells their shares, they'll owe taxes on any capital gains.
If they invested for 30 years, they'd have around $800,000 in capital gains. Depending on their capital gains tax rate, they could either owe $0, $120,000, or $160,000. Most people fall into the 15% capital gains rate bracket, so it'd likely be $120,000.
The person who made the investments in a Roth IRA wouldn't owe a dime when they sold their shares in retirement. Depending on how much you manage to grow in a Roth IRA, the tax savings could easily hit the five- to six-figure range by retirement.
If you're going to be investing for retirement, you might as well get a huge tax break along the way.
Take advantage while you can
One drawback of a Roth is the income limit for eligibility. For tax year 2023, if you're single and have a modified adjusted gross income (MAGI) of less than $138,000, you can contribute up to the limit. If you're married and file taxes jointly, you must make less than $218,000 as a couple to contribute the full amount.
Beyond those limits, the amount that you can contribute declines. If your MAGI is $153,000 or higher ($228,000 or higher if married and filing jointly), you can't contribute to a Roth IRA at all.
At some point, you may find yourself above the limit and ineligible to contribute, so it's best to take advantage while you can. Even if you cross the threshold, your investments will continue to grow and compound until you take withdrawals in retirement.
