IRA stands for Individual Retirement Account. It’s a retirement plan provided by many financial institutions that allows you to save for retirement with tax-free growth or on a tax-deferred basis.
A self-directed IRA provides the opportunity to invest in alternative investments – not just traditional stocks, bonds and mutual funds. Self-directed IRA custodians offer a variety of investments for retirement accounts, including real estate, precious metals, LLCs, tax liens, promissory notes, and both non-publicly and publicly traded securities.
Retirement planners estimate that you may need up to 85% of your preretirement income. So, if you and your spouse are making a combined $100,000 per year, you should plan to save $85,000 for each year after you retire. This means that your 401(k) or other employer-sponsored savings plan may not be enough. It’s recommended that you contribute to both a 401(k) plan and an IRA.
There are two main types of IRAs: Traditional IRA and Roth IRA. The biggest difference between the two is how and when you receive a tax break.
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How a traditional IRA Works
With a Traditional IRA, your contributions are tax-deductible in the year that they’re made. Any earnings can potentially grow tax-deferred until they are withdrawn at retirement. This can also lead to you being placed in a lower tax bracket where your money will be taxed at a lower rate.
The only criterion for being eligible for a Traditional IRA is sufficient income to make the contribution. However, the tax-deductibility of your contributions has strict eligibility requirements based on income, filing status, and availability of other retirement plans. Traditional IRAs also have more restrictions on withdrawals than a Roth IRA.
How a Roth IRA Works
With a Roth IRA, your withdrawals in retirement are not taxed (if conditions are met). A distribution from a Roth IRA is tax-free and penalty-free provided that the five-year aging requirement has been satisfied and one of the following conditions is met: age 59.5, death, disability, or qualified first-time home purchase.
The main advantages of a Roth IRA are its tax structure and the additional flexibility that the tax structure provides. They make the most sense if you expect your tax rate to be higher during retirement than it is currently. Roth IRAs are also subject to income eligibility limits, which means that, if you make too much money, you can’t contribute to one.
Traditional vs. Roth IRA
Each type of IRA has its advantages and disadvantages. You and your IRA custodian will decide what is best for your situation.
Whether you choose a Traditional IRA or a Roth IRA, the tax opportunities allow your saving to compound much quicker than a taxable account. Many factors will play into what is best for you such as your age, income, and current retirement coverage.
The contribution deadline (April 15) is the same for both Traditional and Roth IRAs and the contribution limits vary each year.
The differences in a Traditional vs. Roth IRA are as follows:
|Tax||Tax-deferred growth & tax-deductible contributions.||Tax-free growth & tax-free qualified withdrawals.|
|Age||Contribute until 70½.||Contribute at any age.|
|Income||Income does not affect contributions.||Your income determines contributions.|
|Withdrawal Tax||Pay taxes when you withdraw pre-tax contributions or earnings.||No taxes when withdrawing contributions or paying federal taxes on earnings (if conditions are met).|
|Early-Withdrawal Penalties||If you withdraw before age 59½, you may have to pay 10%.||If you withdraw before age 59½, you may have to pay taxes on your earning plus 10%.|
|Early-Withdrawal Penalties||RMDs must be taken starting at age 70½.||RMDs do not apply.|