No matter your age, you should begin saving for your retirement as soon as you land your first job. According to a 2017 Federal Reserve survey, less than two-fifths of adults age 18 and older believe they are on track with their retirement savings.
Participating in an employer-sponsored retirement program is the easiest way to begin your retirement plan. Moreover, most employers match a portion or all of employee contributions up to a certain percentage with most matching around 6%. By not participating in an employee-sponsored retirement plan, you might be turning down free money!
But, what do you do if your employer doesn’t offer retirement benefits, you’re not eligible to participate, or you’re self-employed? You can still save for your retirement by opening an individual retirement account (IRA). While there are several types of IRAs available, we’re going to focus on the more common traditional and Roth IRAs that individuals usually open.
The traditional IRA was established in 1974 with the passage of the Employee Retirement Income Security Act. The traditional IRA allows you to deposit pre-tax income into an investment account until you reach the age of 70½. Any interest earned in the IRA is tax-deferred. Furthermore, contributions to a traditional IRA may be tax-deductible depending on your income and tax filing status, if you contribute to an employer-sponsored retirement program, and other factors.
You can withdraw from your IRA anytime, but you’ll pay tax on the money. Also, if you are age 59½ or younger at the time of withdrawal, you may be subject to a 10% tax penalty unless you meet certain exceptions defined by the Internal Revenue Service.
You are required to begin making withdrawals by April 1st the year after you turn 70½. The required minimum distributions (RDA) amount is calculated based on your age each year.
The Roth IRA was established under the Taxpayer Relief Act of 1997. Named after Delaware Senator William Roth, the Roth IRA allows you to contribute to your account regardless of your age. However, eligibility and the maximum amount you can deposit annually depends on your modified adjusted gross income.
Unlike an individual IRA, you can’t deduct Roth contributions from your income tax. However, the interest you earn in your Roth is tax-free, meaning you won’t have to pay taxes when you withdraw from your account.
Withdrawals remain tax-free as long as your Roth account has been opened for at least five years and you are age 59½ or older or become disabled. Otherwise, as with the individual IRA, you may be subject to a 10% tax penalty. Finally, you are not required to take an RDA if you are the original owner of the account, i.e. you did not inherit it.
Both the traditional and Roth IRAs have benefits and drawbacks, so how do you choose between the two? Your age and tax bracket now and at retirement age can influence your decision. Your goal should be to select the IRA that will leave you with the most money after you pay taxes.
If you’re just starting out in your career, your salary and your tax rate are probably going to increase over the next 40 or so years until you retire. With that in mind, a Roth IRA may be the better choice.
If you’re older or are getting a late start on your retirement savings plan, you may be better suited for an individual IRA. This is because you will most likely move to a lower tax bracket by the time you retire.
These are only guidelines. Consider your current financial situation as a whole and consult with a financial advisor for guidance. Whichever route you decide to go, with both types of IRAs, you have until Tax Day, April 15th, to make a contribution for the previous year. For 2019, individuals can contribute up to $6,000, $7,000 if you’re age 50 or older. In 2020, individual contribution limits will increase to $6,500 and $7,500.