Roth IRA
A Roth IRA is one the forgotten Investment tools. Most work retirement plans do not offer a Roth which is why most people do not own one. A Roth IRA is one of the most powerful investment tools. Roth IRA’s need to be started early because there are income restrictions when it comes to contributions. The IRS increases the limit yearly however if you are a high-income earner, it makes it difficult to contribute a large amount if any. The have also been increasing the contribution limits so make sure you check before you start contributing. One of the biggest downsides is that Roth contribution is not tax deductible meaning you will not be able to claim the contribution like you can to a traditional IRA. This a small con in the grand scheme of things especially if you start this once you start working. Distributions from a Roth can start as early as 59 and a half if you have had it for at least 5 years.
Let’s talk about what a Roth IRA is. A Roth IRA is a retirement tool that allows tax deferred growth, but distributions are not taxable. This the most effective way to make sure you have a low tax rate in retirement. This works well for the individuals who are still allowed to have a pension like government workers.
Look at this scenario:
Contribution of $3600 (or $300 a month) a year starting at age 30
Contribute for 30 years
Average Return of 8%
$444045.12
This is over $400000 of tax-free money in retirement. In retirement you can change the investment strategy from growth to income. Let’s take that 8% return and turn it to an income strategy. That is $35523 in tax free distributions. That is the equivalent to have a job making close to $50000 a year. If you have a pension this is the best way to add income with having to get a part-time job and the cost is only $300 a month.
If you are a high-income earner don’t worry subscribe to see our next post about Roth IRA conversions and back door Roths through life insurance.
Traditional IRA
A Traditional IRA is a type of retirement account that allows you to make pre-tax contributions. The money in the account can grow tax-deferred until distribution. You are allowed to deduct your contributions to a Traditional IRA based on your income for that year. Each year there is a phase out amount for what you are allowed to deduct from your gross income. Traditional IRA are beneficial if you are a high-income earner now but project that your income will decrease at some point in retirement. You must take money from a traditional IRA the year your turn 72. You also need to plan for the long-term when contributing to an IRA because there are limited number reasons you can withdraw without paying a 10% penalty.
Unreimbursed Medical Expenses
Health Insurance Premiums while unemployed
A permanent disability
Inheriting an IRA
Higher Education Expenses
A home
72 T distribution
To pay the IRS
Older than 59 and Half
A Traditional IRA is not an investment. You can put investments inside the IRA however if you just let the cash sit inside the IRA then it defeats the purpose of tax deferred growth because cash is a depreciating asset. You should start the IRA when you are younger before your peak earning years. If you wait too late you will not be able to contribute enough and you will not have enough time for it to grow unless you are an extremely sophisticated investor.
This is a great tool to have however it is not the only retirement tool. The goal is to have income and assets in retirement. You do not need specific accounts. These accounts are a more effective way however they are not a necessity. Before you decide, you should contemplate all your options by sitting down with a professional.
If you have a hard time budgeting don’t worry subscribe for a future post about work retirement plans.