One of the best strategies to save for retirement is to use a tax-advantaged account such as a 401(k) or 403(b) offered through your employer. However, those work-sponsored accounts aren’t available to everyone — and they aren’t the only tax-advantaged way to build up your nest egg, either. Whether you’re self-employed or simply don’t have access to a 401(k), almost anyone can open up an individual retirement arrangement, or IRA account, and invest for retirement while taking advantage of some useful tax breaks.
How IRAs Work
An IRA essentially functions as a personal 401(k) that you open and operate yourself. This has its advantages — for one thing, while your workplace 401(k) will typically be limited to the bank your employer uses and whatever investment choices they offer, you can open an IRA with virtually any bank or investment broker you want, and your investing options will be nearly limitless.
However, you can’t contribute as much money to an IRA each year as you can to a 401(k). In 2016, combined IRA contributions are limited to $5,500 (or $6,500 if you’re age 50 or older), compared to the $18,000 limit of most 401(k)’s. Plus, you’ll be responsible for making those contributions yourself — they don’t magically vanish from your paycheck before you even see the money, as with a work-sponsored plan.
There are many types of IRAs, but most people are concerned with just two of them: traditional and Roth IRAs. They are similar in many ways, but have very different tax structures with different benefits — so it’s important to know the difference and choose the right one for your financial situation.
A traditional IRA is the most like a 401(k), because the money you put into a traditional IRA is tax deductible this year (unless you also have a 401(k) at work, in which case your deduction may be subject to income limits). That means if you earn $60,000 in 2016 and contribute $5,000 of that to your IRA, your taxable income drops to $55,000 for the year and your tax bill shrinks.
As with a 401(k), with a regular IRA you’re simply deferring the taxes owed on that income until retirement — when you’ll presumably be in a lower tax bracket and therefore less impacted by the tax hit. So when you withdraw that $5,000 (plus any investment gains) two or three decades from now, you’ll pay regular income taxes on it then.
Traditional IRA Eligibility and Limitations
Almost anyone can contribute to a traditional IRA, as long as you have some taxable income and you’re not over age 70-1/2. Combined IRA contributions are limited to $5,500 in 2016 (or $6,500 if you’re age 50 or older).
Traditional IRAs, like 401(k)’s, also require you to start taking minimum distributions after age 70-1/2.
A Roth IRA, meanwhile, has a unique tax advantage. The money you contribute to a Roth IRA isn’t tax deductible this year — meaning the person in our example above, earning $60,000 and contributing $5,000 to a Roth IRA, will still owe taxes on all $60,000 in income this year. However, he or she will be able to withdraw that money — and any investment gains it accrues over the years, which can be substantial — completely tax-free in retirement (after age 59-1/2).
Where a traditional IRA aims to defer your tax burden until retirement, when you’re likely to be in a lower tax bracket, a Roth IRA allows you to take the tax hit now and not have to worry about those taxes in retirement. It also offers the rare opportunity to earn tax-free income in the form of investment gains on your Roth IRA contributions.
A Roth IRA also offers a bit more flexibility than either a 401(k) or a traditional IRA. “With a Roth IRA, you always can withdraw up to the amount you’ve contributed, both tax-free and penalty-free, no matter the purpose,” says financial advisor Matt Becker. You may also be able to use money from a Roth IRA — including earnings — to help with a down payment on your first home or to pay for qualified educational expenses such as college tuition.
Roth IRA: Eligibility and Limitations
Not everyone is eligible to contribute to a Roth IRA — eligibility phases out once your annual income tops $117,000 (or $184,000 if married filing jointly). If you do qualify, you can continue contributing to a Roth IRA after age 70, and hold onto it as long as you live. Yearly contributions are limited to $5,500 ($6,500 if age 50 or older) between all IRAs combined (Roth and traditional).
Which IRA Is Right for Me?
Because of its unique tax benefits and flexibility, we often recommend a Roth IRA to readers if they fall below the income limits. However, both types of IRAs (not to mention other types, such as SEP IRAs) can come in handy depending on your situation and your expectations about future earnings and future tax rates. (For an in-depth comparison of the various retirement accounts available and how they differ, check out our post “Which Retirement Plan Is Right for Me?“)
But in the end, your most important decision when it comes to retirement investing isn’t which type of IRA you choose. It’s not where you open your account, or even which investments you choose.
Nope, the single most important investing decision you’ll ever make is simply to start saving a healthy portion of your income for retirement. More than anything else, the percent of your income that you set aside is going to determine how comfortably you can retire in the future.