Is it time to start thinking about retirement? Yes. In fact, the sooner you start planning your retirement, the easier and more “automatic” it becomes. Plus, early investing results in more money during retirement. So the question isn’t “when” but “how.” This blog will focus on the differences between Individual Retirement Accounts (IRA’s) and Roth IRA’s, as well as the benefits of each.
Bonus Trivia: The term “Roth” is not an acronym. It’s the name of the former United States Senator who helped write the related tax code.
So Many Account Types
First, some assumptions:
For the purposes of this blog, IRA will refer to any tax-deferred retirement account. This could include accounts called IRA, IRRA, SIMPLE, 401(k), 403(b), and others. Any time we refer to an IRA here, we’re talking about a retirement account where the contributions are tax-deferred. In other words, you get to deduct your contributions from your taxable income today but you’ll pay income tax on anything you withdraw after you retire.
Roth IRA will refer to the type of retirement account for which today’s contributions are treated as regular, taxable income but you won’t pay any income taxes on withdrawals during retirement. A Roth 401(k) would fall under this umbrella.
Also, it’s worth noting that you must report taxable income to be eligible for an IRA and/or Roth IRA. Cash from under the mattress does not qualify as a recognized contribution. You have to file taxes and show that your contributions come from yours or your spouse’s income to receive the related tax benefits.
Why Does the IRS Allow Tax-Deferrals?
Does the U.S. government really allow people to avoid paying taxes? Yes, because they know that most employers don’t offer pensions anymore. Scores of workers are set to retire in the coming decades and Uncle Sam can’t afford a bunch of dependents. He’s not that rich! Therefore, it’s on all of us to fund our own retirement accounts. The Internal Revenue Service (IRS) has been offering some lucrative incentives since the 1990s to encourage long-term investing.
Why Invest in an IRA Now?
An IRA is a tax-deferred retirement account. It’s important to mention here that a tax-deferral is not a tax credit. A tax-deferral, also called a tax-deferred expense, is eligible for deduction from your taxable income. For example, if your salary is $40,000 and you contribute $1500 to your IRA, then your taxable salary reduces to $38,500. If you’re in a tax bracket that requires 12% income tax, a $1500 tax deduction means $180 less that you have to pay in taxes this year. Plus, you’ve invested $1500 for the future and that money can now compound while you go about your everyday life. The longer it compounds, the more you’ll have during retirement.
The sooner you start saving for retirement, the longer and harder your money can go to work for you. MSN Money offers a nifty online retirement calculator to help with planning. You’ll see that starting a few years earlier or saving a few hundred extra dollars per year can make a big difference.
If the Regular IRA is So Great, Why Bother With a Roth?
A Roth IRA is its own brand of awesome. Instead of tax-deferred contributions, this type of account reserves your reward for the retirement years. With a Roth, you don’t pay any taxes on your withdrawals. If you need (or want) money for something after your working years are over, your taxable income will not increase because of a Roth distribution.
How Do I Know Which Type of Account to Focus On?
If you start investing early, chances are you can expect to retire with a yearly income that’s higher than what you’re earning today. In this case, the flexibility of Roth funds could be beneficial. Tax laws change and you may find that your tax bracket in retirement is higher than expected. Conversely, if you currently have low expenses, no dependents, and higher income, then a traditional IRA might look more attractive. You could legally avoid a higher tax burden during your working years by participating in a tax-deferred traditional IRA.
In summary: If your income is low enough this year that your tax bill doesn’t scare you, focus on a Roth IRA. If your tax bill is likely to be high this year, focus on a traditional IRA. And don’t worry too much about it. You win either way.
Should I Pay Off My Student Loans First?
No. You should start investing in your retirement account(s) ASAP. It may be tempting to pay-off student loans first since the interest rate looks higher than some stock market predictions. However, the time-value of money will eventually outpace your student loan interest. A good budgeting approach is this: Pay the minimum on your student loans, max out your IRA and/or Roth for the year, then use any extra discretionary income to pay-down your student loan balances.
How Do I Get Started?
Option A: If your employer sponsors a retirement program, and especially if they will match part of your contribution, contact your Human Resources department.
Option B: If you are self-employed or work for an employer who does not offer retirement benefits, contact your financial advisor.
Option C: If you don’t already know a good financial advisor, your CPA can probably provide a stellar reference.
Option D: If you don’t have a CPA (i.e. if you do your own taxes) ask your family and/or friends if they can recommend a great financial advisor. Focus on the family/friends who make good choices with money - not the ones who lease the brand new car and wear the trendiest outfits. Your family and friends who seem secure with themselves and who never complain about money are the folks who are likely to provide the best reference. Also, you can reference brokers and financial advisors yourself via https://brokercheck.finra.org/.
Go For It!
Starting a retirement account is one of the best things you can do for yourself. Most of the financial drama people endure during retirement is self-inflicted. You CAN set yourself on a better path. Go ahead – plan a cushy retirement with loads of spending power. Investing in an IRA, whether it’s the tax-deferred type or a Roth, is one of the best things you can do with your money today. The sooner the better.