When you’re saving and investing for retirement, it’s best to attack it from multiple angles. A 401(k) plan is the most popular type of retirement account because it’s offered through employers, but it should only be one piece of the puzzle.
Another key piece to the retirement puzzle can be an IRA. Unlike a 401(k), IRAs are not employer sponsored and must be opened on your own. There are two types of IRAs: Roth and traditional. Both are great resources, but they offer different tax breaks that make sense for different points in your career.
With a Roth IRA, you contribute after-tax money and get tax-free withdrawals in retirement. You also contribute after-tax money into a traditional IRA, but depending on your income, your contributions may be tax deductible. For tax year 2022, the maximum you can contribute to an IRA (Roth and traditional combined) is $6,000, or $7,000 if you’re 50 or older.
Pay taxes not instead of later
Deciding between a Roth IRA and traditional IRA comes down to one thing: when you pay taxes. If you’re relatively young and early in your working years, it’s likely that your income will be higher down the road as you advance through your career. This also means your tax bracket will be higher. Since you pay taxes on the front end with a Roth IRA, it makes sense to get it out of the way before your rate is higher.
If you’re fresh out of college and making $40,000, you’d much rather pay taxes while your top tax rate is 12%, instead of down the road when you may find yourself paying more than 30%. It also can’t be overstated how great of a benefit it is to have your money grow and compound tax-free.
If you contributed $6,000 yearly into a Roth IRA with an average of 10% annual returns over 25 years, you would have managed to have over $590,000. If those same investments were made in a regular brokerage account, you’d owe capital gains taxes on the profit. But since it’s in a Roth IRA, all $590,000-plus would be tax-free when you make withdrawals in retirement.
Considering you would’ve only personally contributed $150,000, over $440,000 is capital gains, which could easily save tens of thousands of dollars in taxes. The same goes for a traditional IRA. Traditional IRAs have required minimum distributions (RMDs), so even if you didn’t need to take withdrawals, you must do it to avoid penalties. Whenever you take your traditional IRA RMDs in retirement, you pay taxes.
You may eventually be ineligible
As you’re moving through your career and hopefully making more money, remember that Roth IRAs have income limits for eligibility. You can contribute the full amount if you’re single with a modified adjusted gross income (MAGI) of less than $129,000. If you’re married and filing jointly, you need a MAGI of less than $204,000 to contribute the full amount. If your MAGI is $144,000 or higher ($214,000 or higher if married and filing jointly), you’re not eligible to contribute at all.
So before that happens, it’s in your best interest to take advantage of a Roth IRA while you’re still eligible.
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