A great vehicle to help you save towards the goal of retirement is a retirement account. Retirement accounts are tax advantaged accounts that are structured to hold deposits intended for retirement. You can invest your deposits and they will grow tax free, meaning you won't have to pay capital gains on any gains in these accounts.
They can be a great way to reduce your tax burden and help you save more money. There is often a penalty for early withdrawal of funds in these accounts, and generally there are limits on annual contributions (since they are tax advantaged). For optimizing your savings for retirement, definitely look into opening one of these accounts.
There are a handful of different types, each with different tax structures and benefits. In this post I just want to talk about the two main types of retirement accounts as that is what 95% of us will be using. I’ll discuss other types of retirement accounts and their various purposes in other more in-depth posts.
A traditional IRA is a tax deductible account. This means that any money you contribute, you are able to deduct that amount from your taxes that year. As of 2020 the max allowable contribution for individuals under the age of 50 is $6,000. That means if you contribute $6,000 to your IRA this year, you can deduct $6,000 from your taxable income.
IRA’s can grow tax free - they are not subject to capital gains taxes. However, with a traditional IRA you will have to pay income tax on any distributions. If you withdraw funds before retirement, you will have to pay a 10% early withdrawal penalty in addition to income taxes on your distribution.
Another important thing to take into consideration is your income level. Traditional tax deductible IRA’s are only tax deductible for those under a certain earnings level. In 2020, for single individuals, head of household, or married but filing jointly, if you make under $65,000 you are eligible for the full deduction ($6,000 if under 50 years old). If you make between $65,000-$75,000 you are eligible for a partial deduction and anything over $75,000, and anything over $75,000 you are not eligible for any deduction.
Traditional IRA’s are suitable for the vast majority of people, however higher earners may want to look at other options.
A Roth IRA is an IRA that is tax deferred as opposed to tax deductible. What this means is that any money you contribute to a Roth IRA is after-tax income. Your money grows tax free and upon withdrawal you will not have to pay any income taxes (as long as its a qualified withdrawal).
Another cool feature of a Roth is that since you already paid taxes on your contributions, you can withdraw your principal without having to pay a 10% early withdrawal fee. This provides great liquidity, and is an awesome benefit.
Roth IRA’s are also better suited for higher earners that are ineligible for a Traditional IRA. In 2020, if you earn under $124,000 you are eligible to contribute the full $6,000 to your Roth IRA. If you earn between $124,000-139,000 you are eligible to make a partial contribution. If you earn over $139,000, unfortunately you cannot contribute to a Roth IRA.
Which One Is For You?
When considering which retirement account to set up for yourself, the first thing to consider would be your income. What account are you qualified for? If you make over $75,000, (and file as a single individual, head of household, etc.) then that automatically takes the Traditional IRA off the table. I’d recommend a Roth IRA in this case as there wouldn’t be any tax advantage in going with a Traditional IRA at that point. If you make less than $75,000, I would definitely choose to take advantage of the tax deduction offered with a traditional IRA.
Another thing to take into consideration (assuming both options are available to you based on your level of earnings) is current and future tax rates. If you believe taxes will be higher for you in the future, you’ll probably want to opt for a Roth IRA and pay lower up front taxes. In the end, in most cases the deciding factor will be your level of income and which account you are eligible for.
As you can see, Retirement Accounts can be a great instrument to maximize your savings. I would definitely recommend everybody utilize the account most suitable for you. These are invaluable instruments when used correctly to save for the later years!