Seconday Savings for Retirement-Individual Retirement Accounts (IRA’s)
Roth IRA vs Traditional
One of the most popular questions I get as a Financial Advisor is whether a client should be investing in either a Roth IRA or Traditional IRA? The answer…It depends.
Probably not the answer your were looking for right, but Let’s explore the basics of the Individual Retirement Accounts (IRA’s) prior to giving an actual answer.
An IRA is an account devoted to your retirement savings. It is in your name and your name only. A spouse or other individual can be a beneficiary on the account, but the account is specifically for the name holder. IRA’s are designed for you to add additional money towards your retirement in addition to your 401k plan. You also have the ability to choose from a wide variety of investment options such as stocks, bonds, exchange traded funds, and mutual funds. You also can have the account managed by a professional, but it all depends on your comfort of managing your own money.
There are two types of IRA’s, the traditional and the Roth.
Traditional IRA’s allow you to contribute pre-tax money to your account. Once the money is invested and the money begins to grow, the earnings are all tax deferred. Contributions to the account can be considered tax deductible depending on your income. When you retire and start withdrawing, the money is taxed as ordinary income.
Roth IRA’s allow you to contribute after tax money to your account. When the money is invested, the earnings grow tax free. Contributions to the account are not tax deductible. Unlike the traditional IRA, when you start to withdraw money from the account in retirement, all gains are tax free and there isn’t a tax liability. This can be a great way to reduce tax obligations in retirement.
Contributions to IRA’s have their own rules. IRA’s allow an individual below the age of 50 to contribute $6,000 per year to their account. If you’re older than 50, then the contributions increase to $7000 per year, this is called the catch up amount.
It’s also important to note that not all earners are eligible for Roth IRA contribution or tax deductions. There are income phase outs, and this will be covered in another article.
So what is the best option for individuals?
Again it depends, but to be more concrete, look at your own financial picture and ask yourself…
How much can I contribute?
Do I want my money managed or do I want to manage it myself?
Do I need more tax deductions?
Will I pay more taxes in Retirement?
Let’s look at an example.
John is a 35 year old software engineer. He makes 100,000 per year and contributes 10% of his salary to his 401k plan. Sam is looking to save additional funds towards his retirement and would like to buy some individual stocks. John doesn’t really think he needs any more tax deductions, but will speak with his accountant for guidance. John also believes he will pay more in taxes during retirement.
What could John choose?
John could invest in the Roth IRA since he is not concerned with tax deductions. He also believes that he may pay more in taxes during retirement. Therefore, if he pays the tax now, he could have tax free withdrawals in retirement. All of his gains could also be tax free. Since John would like to purchase individuals stocks and manage his portfolio, an IRA would allow him to invest in the individual securities. A Roth IRA maybe a suitable option for John.
Saving for retirement can be a challenge for many individuals. The majority of people don’t realize that IRA’s are completely separate from their employer plan. Contributing to both your 401k and IRA will help maximize your chances of reaching your retirement income objective.
If you have questions about your financial picture feel free to reach out to us for a consultation.
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