Now that you have made the conscious decision to start saving additional funds for retirement outside of your employer-sponsored plan, you should consider one of two options so your money is working as hard as it can for you. There are two popular ways to save for retirement, and they are both a form of an individual retirement account (IRA).
Saving Pre-Tax Dollars in a Traditional IRA
The first type of IRA is a Traditional IRA. This account allows individuals to save pre-tax dollars in an investment account specifically for retirement. Under the current tax code, interest, dividends and capital gains are all deferred under this account, meaning you will not have to pay any tax on these earnings on an annual basis until you reach retirement and start to take withdrawals. Speaking of withdrawals, since the government has so generously given you tax-deferred growth all of those years, once you take money out of the account in retirement, all of your withdrawals are classified as ordinary income and is taxed as such. Currently the following restrictions are placed on traditional IRAs:
- You must be age 59.5 to access your account without incurring a 10% penalty in addition to paying ordinary income tax on any withdrawal.
- The annual contribution limit for a traditional IRA is $5,500 per individual. An individual taxpayer may elect to contribute 100% of their earned income up to $5,500. Individuals age 50 and older may contribute an additional $1,000 as a catch-up provision to help boost retirement savings. (For related reading, see: Traditional IRAs: Contributions.)
- The government mandates that since they have generously provided you with tax-deferred growth for all of your working years, at age 70.5 you must start taking what are called required minimum distributions (RMDs). They do this so they can start to recoup some tax revenue from your years of deferrals.
- A traditional IRA contribution can be tax deductible depending on the government’s tax tables.
- If you are single…
- and your modified adjusted gross income (MAGI) is $62,000 or less, your full contribution amount is deductible.
- and your MAGI is between $62,000 and $72,000, you are eligible for a partial deduction.
- and your MAGI is more than $72,000, you are not eligible for a deduction on your contribution.
- If you are married…
- and your MAGI is $99,000 or less, you are eligible for a full deduction of your contribution.
- and your MAGI is more than $99,000 but less than $119,000, you are eligible for a partial deduction.
- and your MAGI is $119,000 or more, you are not eligible for a tax deduction.*
- If you are single…
It is important to remember that as long as you have earned income, you are eligible to open and contribute to an IRA, it just may not be tax deductible. (For related reading, see: 5 Secrets You Didn't Know About Traditional IRAs.)
The Benefits of Roth IRAs
The second kind of IRA is a Roth IRA, which is named after Delaware Senator William Roth and was established by the Taxpayer Relief Act of 1997. The biggest distinction between a Roth IRA and traditional IRA is the matter in which they are taxed. Roth IRAs are funded with post-tax dollars and the contributions are not tax deductible. Even though you are given no tax benefit for contributing to a Roth IRA on the front end, all Roth IRA withdrawals are tax-free.
Another major benefit of the Roth is because the distributions are tax-free, the government does not impose a required minimum distribution policy like they do on traditional IRAs. There are some income limitations set on people interested in opening and contributing to a Roth IRA. Generally, you can contribute to a Roth IRA if you have taxable income and your MAGI is either less than $129,000 if you are single or less than $191,000 if you are married.
In most cases it is beneficial for younger savers to open a Roth IRA since they are presumably in a lower tax bracket and still eligible to contribute to take advantage of 30-plus years of tax free growth. In either case saving a bit before retirement can really boost your savings in the end. It is never too late to open an account and start saving.
(For more from this author, see: The Real Benefit of a High Deductible Health Plan.)
*Please consult with your tax professional regarding the eligibility and deductibility of your IRA contributions.