When you’re ready to start saving for retirement, one of the first things you’ll need to do is figure out the best places to stash your cash.
First, consider your employer’s retirement plan. That’s especially true if your employer offers matching contributions. “You really need to contribute enough to get that match," says Shanda Sullivan, a certified financial planner in Broken Arrow, Oklahoma. Otherwise, you're essentially leaving free money on the table.
But what if your employer doesn’t offer a match or even a retirement plan? Then investing in an individual retirement account, or an IRA, is a great option.
IRAs come in two basic types – traditional and Roth. The differences between the two varieties are substantial and can affect how much you will have in retirement. Here’s how to decide which IRA is best for your situation:
Taxes now or later?
Each type of IRA comes with its own rules and advantages, but one critical issue to consider is taxes. In a nutshell, a traditional IRA offers a tax break on your contributions, while a Roth gives you the break on earnings and withdrawals. The question, Sullivan says, investors need to ask themselves is this: "Are you going to save on the front end when you contribute or on the back end when you retire and take the money out?"
In most situations, the tax advantages of a Roth are stronger. To illustrate the tradeoffs, let's say you are in the 28% federal income tax bracket, contribute a total of $100,000 to an IRA, and over 30 years the balance grows to $575,000. Here’s how your contributions and earnings would be taxed:
| Traditional IRA | Roth IRA | |
| $100,000 contribution (assuming at 28% federal tax rate at time of contribution) | Pay no federal taxes on the $100,000 at the time of contribution | Pay $28,000 in federal taxes on the $100,000 at the time of contribution |
| $575,000 withdrawal when you retire (assuming a 10% federal income tax rate at time of withdrawals) | Pay $57,500 in federal taxes on the $575,000 you withdraw upon retirement | Pay no federal taxes on the $575,000 you withdraw upon retirement |
|
|
$517,500 | $547,000 |
As you can see, when you make that the withdrawals from the traditional IRA, you still pay $57,500 in federal taxes, more than double the federal taxes you would pay on the Roth contribution.
Many people expect income tax rates to rise from near historic lows as federal and state governments deal with the entitlement expenses of an aging population of baby boomers. If tax rates are rising, a Roth IRA is an even more attractive tax shelter than a traditional IRA because your contributions will be taxed at a lower rate than your earnings.
“The way I look at it, Roth IRAs are like tax insurance," says Jeff Levine, chief retirement strategist at IRA consulting firm Ed Slott and Company. "There are so many unknowns when it comes to retirement. If I can eliminate one of those unknowns, I like that. With a Roth, I know I don't have to worry about future taxes."
Traditional IRAs can be the better choice for some retirement savers. For example, you may want to contribute to a traditional IRA if you have income from a freelance project and the taxes on that income weren’t withheld. In that case, contributing to a traditional IRA will trim your current tax bill because the contribution will lower your taxable income and allow you to pocket the tax savings now.
Bonus benefit
Roth IRAs come with more flexibility than traditional ones. If your Roth has been open at least five years, you can withdraw your contributions at any time, without having to pay any taxes or penalties. A traditional IRA don’t provide this perk.
Know the rules
The tax benefits of traditional and Roth IRAs come with their own sets of rules, tied to earnings and age.
| Roth IRA | Traditional IRA | |
| Tax benefits | Contributions are taxed, investments grow tax-free and withdrawals are tax-free. | Contributions may be tax-deductible, investments grow tax-free, but withdrawals are taxed. |
| Contribution limits | Up to $5,500 per year (or $6,500 for those 50 and older). | Up to $5,500 per year (or $6,500 for those 50 and older). |
| Age eligibility | No age restrictions. | Must be under age 70½ to contribute. |
| Income eligibility | Income limits apply. | No income limits to make contributions. |
| Penalties at withdrawal | Non-qualified withdrawals are subject to taxation of earnings and a 10% additional tax unless an exception applies. | Withdrawals before 59½ may be subject to a 10% early withdrawal penalty unless an exception applies. |
| Minimum required distributions | No minimum required distributions. | Minimum yearly withdrawals generally starting in the year you turn 70½. |
One big drawback to Roth IRAs is you can only contribute to a Roth IRA if your income is below a certain threshold. For single filers in 2016, that threshold starts at $117,000 and ends at $133,000. For married filers in 2016, that threshold starts at $184,000 and ends at $194,000. In those income threshold ranges, your Roth IRA contributions are limited. If you make more than the threshold, you can’t contribute to a Roth.
But if you are eligible to contribute to a Roth, your heirs will love you. Since Roth IRAs don’t have required minimum distributions, they can be useful tools for passing on an inheritance. “For people looking at wealth transfer, a Roth is the way to go,” Levine says. “It allows a significant tax-free benefit for heirs.”
Whichever type of IRA you choose, you’ve already taken a great first step by deciding to save for retirement. Your next choice — where to put that savings — is just about maximizing your wealth for the future.
