It pays to save for your future, whether you are just starting out or have an employer-sponsored retirement plan. Individual retirement accounts, or IRAs, are savings accounts that you invest, rather than just earning interest on in a bank. While the risk is higher, the potential returns can also be higher than bank interest. IRAs are a special class of “tax-advantaged” investment accounts created by the government to encourage Americans to save for their future – and everyone who can should take advantage!
For the most part, the different kinds of IRAs vary in how exactly they’re ‘tax advantaged’, which means when you pay taxes on the money, but there are also differences in eligibility and withdrawals. Read about the different kinds of IRAs below.
Contributions made to a traditional IRA are fully tax deductible in many cases, allowing you to defer paying tax on your retirement contributions until you actually withdraw the money. However, everything you accrue is taxed, including any interest or returns gained over the years. Contributions are capped at $5,500 a year ($6,500 if you are age 50 or older).
It is important to note that if you (or your spouse) are also covered by an employee retirement plan, you may be unable to deduct all of your contributions. If you tap into your money before the age of 59½ you can expect to be penalized, and once you reach the age of 70½ withdrawals are compulsory You can find more information about Traditional IRAs here.
The inverse of a Traditional IRA, a Roth allows you to invest money you’ve paid income tax on. When you eventually withdraw your investments, they’re tax-free, provided that the money has been in the account for at least five years and you are older than 59½. Your eligibility to invest in a Roth IRA is down to your income and some high earners are unable to contribute. To find out if you qualify check here. Like the Traditional IRA, if you dip into your money before the age of 59½, you’ll be subject to a penalty. However, you can leave money in your Roth IRA beyond the age of 70½ if you so desire.
A Simplified Employee Pension (SEP) is a retirement account suitable for independent contractors and freelancers. SEPs are also used by small businesses to provide retirement contributions to employees on a flexible basis. Similar to traditional IRAs, contributions are tax deductible. You can add up to 25% of your earnings to a SEP, as long as this amount does not exceed $55,000. Like the other IRAs, you will be penalized if you remove money before the age of 59½ and you will need to start withdrawing your savings at the age of 70½. You can find out more from the IRS here.
Which one should you choose?
Deciding which is best for you is down to your personal financial circumstances and preferences. Younger people may be better suited to Roth IRAs, as those starting out in their careers are often paying tax on a lower bracket. Those at peak earning power could be better served with traditional IRAs if you make the assumption they could retire on a lower tax bracket.
The opportunity to take out your money and the interest you’ve accrued tax-free at retirement age is a big draw for those investing in a Roth IRA. However, the tax you’ll pay upfront should not be overlooked. For example, if you’re taxed in the 25% bracket and want to add the full yearly contribution of $5,500 to your Roth IRA, you’ll need to factor in an extra $1,833 to cover taxes – a total of $7,333. And if you earn more than a Roth IRA allows, that option is already off the table.
In contrast, if getting a tax break up front appeals to you then you might opt for a Traditional IRA. What percentage you’ll give up in tax once you retire depends on the tax bracket you are in at that time. Unfortunately, none of us can predict how tax laws will change over the years. Each option has its benefits and should be carefully weighed up, taking into account your current career or life stage.
Alternatively, if you are self-employed and able to put away a considerable nest egg, you may like the benefits of a SEP.
You can hold more than one IRA, though the contribution limit goes for all accounts (eg. if you have both a Roth and a traditional IRA, you have to split the $5500 between both.) Regardless of your circumstances, you should consult a professional to talk through the best options for you, and get started investing for the future!