The Scoop on IRA Basics

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photo credit: Unsplash/Jon Flobrant

Roth or Traditional IRA? It Depends.

What’s an IRA?

An individual retirement account (IRA) is a way for you to save and grow your money, typically over a long period of time (think a couple of decades).

You contribute money to your IRA, and you choose how to invest your money in order to get the best return. It all depends on how much risk you want to take.

You can actively choose your investments, or you can work with a broker who does most of the choosing for you. You’ll want to monitor the broker’s administrative fees to make sure you’re getting a good deal.

  1. Traditional IRA

    The traditional IRA lets you make contributions without paying taxes on the money right now, which means more money working for you to generate compound interest and investment gains over time. However, you will pay taxes when you withdraw the money.

    The IRA is intended for long-term retirement investing. You can start to take withdrawals from your account without penalty at age 59 ½ and you are required to start taking withdrawals at age 70 ½.

    If you take early withdrawals or loans from your IRA, you likely will pay large penalty fees and taxes.

    See the fine print on IRAs, including contribution limits and exceptions.

  2. 401(k) vs. IRA

    A 401(k) plan has many of the same rules as the traditional IRA, except that 401(k)s only are offered through employers.

    If you have a 401(k) through work, ask the human resources department for a copy of the Summary Plan Description. This document describes your plan’s administrative fees, investment choices and withdrawal options.

    You might have to do some work to dissect and understand this information, but it’s worth the effort to grow your money faster.

    Employers often match 401(k) contributions up to a certain percentage, which essentially is free money. Take advantage of that perk. If you don’t have a 401(k) or your employer doesn’t match, you might want to open your own IRA.

  3. Roth IRA

    A Roth IRA flips the tax scenario from the traditional IRA and 401(k). With a Roth IRA, you pay taxes when you make the contribution, but you do not pay taxes when you withdraw the money.

    This allows your money to grow without the looming threat of future tax payments. You still have to wait until age 59 ½ to make withdrawals without paying a penalty, but there is no age when you must start taking withdrawals.

    See the fine print on Roth IRAs, including contribution limits and exceptions.

  4. Traditional IRA Makes Sense for …

    A traditional IRA, where you pay taxes later, can be a better fit if you are an established worker who wants to supplement your 401(k) plan or do your own retirement saving.

    Putting off taxes now means that there is more money in your account to grow over time, which is helpful for people who don’t have a lot saved and who don’t expect to jump to a higher income bracket after they retire.

    The growth of your IRA will depend on:

    • How much you contribute — the more you put in, the more principal you have to grow interest.
    • The risk level of your investments — riskier investments can mean higher payoffs, or bigger losses.
    • How long you let the money grow — the longer you let it sit, the more interest compounds in your favor.
  5. Roth IRA Makes Sense for ...

    Paying taxes now rather than later in a Roth IRA can make sense for:

    • Future high earners. If you currently don’t earn much, but you are getting your degree in a high-income field, you might consider a Roth IRA because your future income bracket and the potential of higher overall tax rates when you’re ready to retire mean you would be better off taking the tax hit now.
    • Retirement savings superstars. If you already have a lot of assets in a traditional 401(k) and currently make a high income, the Roth IRA can be a good choice because today’s tax rate likely is lower than the tax rate of the future.

Everything depends on your specific situation. Start with your employer’s offerings, take advantage of matching contributions and expand your exploration of IRA basics from there.

As always, we’ve got your back. – The OYO Team

[Any reference to a specific company, commercial product, process or service does not constitute or imply an endorsement or recommendation by On Your Own, the National Endowment for Financial Education or any of its affiliate programs.]