What are IRA’s anyway?
IRA is an acronym for Investment Retirement Account. The two main types of IRA’s are called Traditional & ROTH. The Roth IRA is the youngest of the two, started by Delaware Senator, William Roth, in 1997 as a part of the Taxpayer Relief Act. IRA’s act like any other type of brokerage account, you can purchase Stocks, CDs, Mutual Funds, ETFs, Bonds or simply just cash.
The Traditional IRA allows you to contribute up to $5,500. (The maximum contribution amount increases periodically from year to year to adjust for cost of living) The money you contribute to a Traditional IRA is considered “pre-tax” money, therefore reducing your taxable income. If you make $50,000 a year you would be able to take that $5,500 Traditional IRA contribution OFF of your reported, taxable income. All of that money you put into the IRA will grow in your account until the day you start withdrawing it, at which the money is taxed at your regular income tax rate. Caveat: You are required to start withdrawing from a Traditional IRA at age 70.5. The amount you are required to withdraw depends on your own personal situation. If you decide you need the money before retirement age, you are usually taxed a 10% early withdrawal penalty unless you are pulling it out for a qualified purchase such as a first-time home purchases, college, or medical expenses.
The Roth IRA also allows you to contribute up to $5,500 each year, but the money you contribute to a Roth IRA is “post-tax” money, therefore you do not get a reduction to your taxable income based on your contributions unlike a Traditional IRA. The benefit to a Roth IRA is that when you pull your earnings out, you pay ZERO taxes on all gains within that retirement account. You also are not required to make withdraws at a certain age, so you can let your money grow for even longer. Another benefit is that if you ever want to pull your money out early, you can take out your original contributions without penalties, but you must remember that you can never make up money that was contributed in past years.
There are some income restrictions when contributing to a Roth IRA. I’ve borrowed this chart from The Motley Fool to help explain the limits.
|Tax Filing Status
||AGI Limit for Full Contribution
||Partial Contribution Allowed
|Single/head of household
||$133,000 or more
|Married filing jointly
||$196,000 or more
|Married filing separately
||$10,000 or more
The maximum yearly contribution of $5,500 applies to both the Traditional and Roth IRA’s meaning you can contribute up to a total of $5,500 to a combination of both accounts. So if you put $2,500 into a Roth account, you can only put $3,000 into a Traditional or any combination of such.
After age 50, you are allowed an extra yearly “catch-up” contribution of $1,000 to help make up for missed savings.
15 Months. That’s the actual amount of time each year to max out your IRA of either type. So you have from January 1st until April 18th (tax-day) to contribute to your accounts, but if you max out early, you can start contributing to your next-year’s IRA’s early too.
What to choose? Great Question!
If you are like me, then you are probably still confused as to what type of account you should contribute to and you are not alone and it depends… If you are trying to retire early, the Traditional IRA is probably your best bet. The reason being that you are reducing your taxable income every year which allows for more money to be socked away into investments. Plus, during your early retirement you will most likely have an income lower than your current income and possibly even below the taxable income limit which means you can actually withdraw the money from your IRA at a very low tax rate (10%) if any tax rate at all allowing you to get double the tax deductions later in life.
No matter which option you choose, the most important thing to take away is that you MUST max out one of the accounts every single year. IRA’s are one of the most beneficial retirement vessels that Uncle Sam provides, so take advantage of them immediately!