Saving money for retirement can seem like an overwhelming task. With dozens of different options for savings and capital growth, it’s easy to get confused about which one is right for you. Fortunately, a retirement account makes it all very easy — an Individual Retirement Account or IRA. This article will discuss how an IRA works, the benefits of having one, and the pros and cons of the two most common types of IRA accounts.
The Pros and Cons of Roth IRAs versus Regular IRA
Saving money for retirement can seem like an overwhelming task. With dozens of different options for savings and capital growth, it’s easy to get confused about which one is right for you. Fortunately, a retirement account makes it all very easy — an Individual Retirement Account or IRA. This article will discuss how an IRA works, the benefits of having one, and the pros and cons of the two most common types of IRA accounts.
What is an IRA?
An IRA is a retirement investment account that individuals can set up to build their savings in preparation for retirement. One of the great benefits of using an IRA is that people who use them get to take advantage of special tax incentives. Strategically saving money on taxes over the length of your career can add up to thousands of additional retirement dollars.
Several types of IRA accounts are available to individuals, including a Traditional IRA, Roth IRA, SEP-IRA, and SIMPLE IRA (SIMPLE stands for Savings Incentive Match Plan for Employees). Each one is different, so you will need to evaluate your options carefully. However, the most commonly used IRAs are Traditional and Roth.
What is the Main Difference between Traditional and Roth IRAs?
The main difference between Traditional and Roth IRAs is when they are taxed. When contributions are made to a Traditional IRA, the money is tax-deductible. Taxes are only due when you withdraw money from your retirement account. Contributions to a Roth IRA, on the other hand, are taxed when you are paid. However, when you remove the money at a later date, all contributions and growth are tax-free. Depending on your financial situation, one option may be better than the other.
How Do They Save You Money?
In the case of a Traditional IRA or Roth IRA, the tax savings can save you thousands of dollars and help you reach your retirement sooner than using other investments options. If you invest money into the stock market through a standard brokerage account, you will pay taxes on any income received (like interest or dividend payments) and any realized capital gains. . With a Traditional IRA or Roth IRA, you only have to pay taxes on one or the other.
Pros and Cons of a Traditional IRA
Pros
Since taxes remain deferred until retirement, you could see significant tax savings if you anticipate that your income at retirement will be lower than your current rate. It helps you avoid taxes when you are in a higher tax bracket and pay later when your tax bracket is lower. Another benefit is that money that would have gone toward taxes stays invested, which means your account will grow faster.
Cons
Traditional IRAs have rules around contributions and withdrawals that you must follow. First, you must be under the age of 70 ½ to make contributions. This usually isn’t a problem since most people have retired by this age and are no longer saving for retirement. You will be required to withdraw a portion of your money (and pay taxes on it) each year once you hit the age of 72.
Pros and Cons of a Roth IRA
Pros
The best benefit of a Roth IRA is that deposits into a Roth are made with after-tax dollars. Therefore, money taken out of your account at retirement won’t be taxed again. This is true for both contributions and the growth of your investments if you do not take the growth out until after age 59 ½. Any growth that has withdrawn before age 59 ½ is both taxed and penalized by being subjected to a 10% fee.
If you expect your income to be higher at retirement, a Roth IRA will allow you to pay taxes when your payment is lower and withdraw your money tax-free when you are in a higher tax bracket.
A Roth IRA lets you continue contributing anytime and has no required minimum distributions (RMD). You won’t be forced to pull out money when the market is not looking good.
Cons
Your money will be taxed first, which means you will have less money going into your retirement account. For example, if your tax rate is 20%, $500 worth of income would only contribute $400 to your account.
You cannot contribute to a Roth IRA if your income exceeds $140,000 in the year 2021. There is a perfectly legal loophole for high-income earners called a backdoor IRA. You put your money into a traditional IRA and immediately roll it into a Roth IRA. However, this means having to manage two different accounts.
If you’re pondering this situation, whether to invest all at one, please feel free to reach out to me at Chase Thomas chtomas@alphawealthfunds.com and I’ll be happy to discuss it and possibly show you better strategies to accomplish your goals.