2 Basic types of IRAs
According to Fool.com, there are eleven (count ’em) different types of IRAs. Luckily, for a beginner’s retirement savings purposes, we only really need to know about the two most popular types.
1. Traditional IRA
A traditional IRA is what most people have when they elect to participate in any kind of employer-sponsored retirement plan. It is the "original" IRA type—the oldest and best known—and what most people refer to when they say "my IRA."
Here are the highlights of what a traditional IRA offers:
- You can contribute up to $5,500 of your annual income into a traditional IRA ($6,500 if you are age 50+) up to age 70 ½.
- There are no income restrictions (i.e., no matter how little or how much you make, you may open a traditional IRA).
- Whatever amount you choose to contribute per year will reduce your gross annual taxable income by that amount.
- If you choose to make excess contributions, those contributions will only be taxed at 6%.
- You won’t have to pay any taxes on that money (per some IRS-mandated restrictions which may or may not apply) at the time of the contribution.
- You may begin to withdraw funds when you reach age 59 ½ (and must begin by age 70 ½ to avoid penalties). These withdrawals, called "distributions," will be taxed as part of your annual income at the time of withdrawal.
- If you with choose to withdraw any/all of the funds before you reach age 59 ½, you will be assessed a 10% penalty plus the withdrawal will be taxed as part of that year's annual income.
Savings Tip: The single biggest way to save money now through opening a traditional IRA is to shelter a part of your annual taxable income in a tax-free fund.
2. Roth IRA
The Roth IRA didn't come into being until 1997 (as a part of the Taxpayer Relief Act of that same year). The Roth IRA offers a very different way of investing into your future. Depending on who you ask, some financial planners believe the Roth is a better option than the traditional IRA. What matters most is to choose the retirement savings vehicle that best meets your investment and savings goals (you can also open both a traditional and a Roth IRA, which many people choose to do).
Here are the highlights of what a Roth IRA offers:
- You can contribute up to $5,500 of your annual income into a Roth IRA ($6,500 if you are age 50+) with no age ceiling (i.e. you can continue to contribute at any age).
- Any individual who earns up to (but not more than) $95,000, or any married couple who jointly earns up to (but not more than) $150,000 may open a Roth IRA.
- All contributions are taxed at the time of the contribution, so they are tax-free upon withdrawal (an option which begins at age 59 ½) as long as they have been held in the Roth IRA account for at least five years prior to withdrawal and a few other IRS-mandated requirements have been met.
- There is no mandatory age at which you must begin to take distributions.
- You will be assessed a 10% penalty for withdrawals before age 59 ½ unless those withdrawals are made for purposes of purchase of a first home, hardship medical premiums payment, permanent disability, and a few other IRS-mandated exceptions.
Savings Tip: The major way that the Roth IRA can save you money now is by ensuring you will not later have to pay more taxes due to the growth of your principle (i.e. due to accrued capital gains, dividends, interest income, rents, and other common investment benefits).
Traditional + Roth IRA NOTE: If you choose to open both a traditional and a Roth IRA, you may only contribute up to the annual IRS-mandated limit (for most people, $5,500 in 2014) to both funds in one calendar year. For instance, if you choose to contribute $2,500 to your traditional IRA, that means you then may only contribute $3,000 to your Roth IRA in that calendar year).
Which IRA saves you more: a handy calculator
Before you decide which retirement savings tool to select, you may find it helpful to calculate your estimated savings with each tool. This handy Bankrate calculator can help. You can change around the numbers and also use the "maximize contributions" tool to see how small changes can add up to bigger returns. I have completed a sample calculation here as a demonstration you can follow.
- Current Age: I input a current age of 32 (halfway to the average retirement age of 65).
- Age of retirement: I input a retirement age of 65.
- Adjusted gross income: I input $50,000 (average annual income as of 2012).
- Annual contribution: I input $5,000 (a 10% contribution annually).
In this sample calculation, the contribution from age 32 to age 65 worked out to be $165,000.
- Value of $165,000 at age 65 in a traditional IRA (+ tax deferred savings): $651,404
- Value of $165,000 at age 65 in a Roth IRA: $636,294