Retirement planning is essential at all stages of your life. The earlier you begin, the more significant the impact your efforts may have once it is time for you to make the move and retire. Many people mistakenly believe that the only viable solution for retirement saving and planning is employer-sponsored retirement plans or operating on the stock market (a method that often requires a sizeable nest egg and no small degree of risk). The good news is that other options are available, including IRAs (individual retirement accounts) and Roth IRAs. The better you understand these options, the wiser decisions you can make in your retirement planning efforts.
Traditional IRAs
Traditional and Roth IRAs have similar goals – to help you save money for retirement. The differences in the two types of accounts set them apart and may make one account a better choice for you. These are a few key details to consider about traditional IRAs.
You fund traditional IRAs with pre-tax money, allowing both your contributions and their earnings to grow tax-deferred. Anyone with earned income can contribute to a traditional IRA. For 2023, the contribution limits are $6,500 for most individuals and $7,500 for those over 50. While you can withdraw funds penalty-free after age 59.5, those distributions are taxed as current income. After turning 73, you must start taking distributions. Many individuals favor traditional IRAs for their immediate tax advantages, especially those who anticipate retiring in a lower tax bracket.
Roth IRAs
Roth IRAs differ from traditional IRAs in several ways. Primarily, you fund them with after-tax money, allowing the contributions to grow tax-free. While you don't get tax deductions when contributing to a Roth IRA, your withdrawals are tax-free. However, eligibility requirements exist: You must have earned income below a specified threshold to contribute to a Roth IRA. For 2023, the contribution limits are $6,500 annually for those under 50 and $7,500 for those 50 and older.
Roth IRAs require no minimum distribution age and can grow in value as long as you like without requiring you to accept distributions. While tax-free disbursements are appealing, Roth IRAs are better suited for people who plan to be in a higher tax bracket upon retirement. Since Roth IRAs are not taxed, you must understand that you must meet specific requirements to receive tax and penalty-free distributions. Roth IRAs are tax and penalty-free after you have held the investment for five years AND reached the age of 59.5.
Eligibility and Contribution Limits
Considering that the average income in the United States for 2023 is $59,428, most people fall within the income limits for Roth IRAs, which are $153,000 for single tax filers and $228,000 for married or joint filers. Traditional IRAs have no maximum income restrictions, though you must earn some income to fund either type of IRA. There are yearly maximum contributions whether you’re enjoying tax-free or tax-deferred investments. The most you can invest in your IRA annually is $6,500 before age 50 and $7,500 after age 50 (as of 2023). Those rates are subject to annual adjustments. Check with the IRS or your financial advisor for the most up-to-date numbers.
Withdrawals
When you retire, you can withdraw funds from both traditional and Roth IRAs without penalties. Additionally, Roth IRA withdrawals during retirement are tax-free. Before retirement, you can only take funds from a Roth IRA without penalties under specific conditions. Firstly, you must have held the IRA for at least five years. Additionally, you must meet one of the following criteria.
- You are 59.5 years of age or older.
- You have a permanent disability.
- You have died, and your estate is withdrawing the money.
- As a first-time home buyer, you use the money (up to $10,000 as a lifetime maximum).
If you don't adhere to these restrictions, you'll incur a 10% penalty, which many aim to avoid. Moreover, those who withdraw early from traditional IRAs face a 10% penalty and taxes, treating them as earned income for that year.
Choosing an IRA
Your IRA choice will likely come down to your current tax bracket vs. your anticipated tax bracket upon retirement. Many anticipate retiring in a lower income bracket and prefer the tax savings now instead of later. However, suppose you’re one of the few who believes you’ll be experiencing better financial times upon retirement. It might be worth considering the tax-free earnings Roth IRAs represent in that case.
IRAs and Your Retirement Strategy
IRAs shouldn't serve as the sole foundation of your retirement planning. Yet, if you start investing early and consistently maximize your yearly contributions, they can significantly boost your retirement funds. Consulting a financial advisor can further optimize the benefits of IRAs for your retirement income.
Takeaways
While not intended as the whole of any retirement strategy, traditional and Roth IRAs can play pivotal roles in your overall comfort level upon retirement. Use them wisely to help supplement your retirement strategy.