My Comments: Given our inability to accurately predict the future, it’s very difficult for most people to effectively plan for an event that will happen years into the future.
Assuming we live long enough, however, the odds of that event appearing in front of us are very high. I’m talking about a point in time when you quit working for money and money starts working for you.
You might refer to it as a traditional retirement, or more likely in today’s world, when generating new income so you can pay your bills becomes tedious if you’ve set aside the necessary resources to allow that happen.
Here in the US, most of us have the ability to set aside a percentage of our current earned income for use in the future. These words from Erin Lowry are a great way to better understand what you should do now to avoid pain in the future.
by Erin Lowry \ 22 APR 2021 \ https://tinyurl.com/yduprfo6
“Should I open a Roth or Traditional IRA?”
Like most money experts, I get asked this question a lot. And it makes sense. Choosing an account that’s supposed to guide you all the way to retirement is stressful. It feels like picking the wrong one can somehow set you back or screw up your ability to retire.
But debating about this topic forever can make you feel overwhelmed. Sometimes, the worst can happen and you choose neither, needlessly delaying your retirement progress from the beginning.
Here’s the truth: Whichever account you choose will help you set up a path for retirement, and that’s one of the most important money decisions you can make in your life. We all want to be able to live a comfortable, financially independent retirement.
Why You Should Care About Roth and Traditional IRAs
Let’s clear something up. An IRA is an individual retirement arrangement. (Some people say “accounts” but the IRS says “arrangement,” so we’re going with that!)
Typically, when you hear about saving for retirement, you might think about a 401(k). They are employer-offered retirement plans that sometimes come with an employer match. IRAs are another way to set aside money for retirement in a tax-advantaged way. An IRA is a way to invest for your future that you can open by yourself without an employer. This can be particularly helpful if you don’t have access to an employer-sponsored retirement plan.
Think of it like this: the 401(k) is a big ol’ house and an IRA is a nice apartment. Two different sizes, but both are nice places to live.
What’s the Difference Between Roth and Traditional IRAs?
The difference is simply about when the money is taxed.
In Roth accounts, you are contributing money post-tax, meaning you’ve already paid taxes on it that year. The perk is that you get to take your distributions out tax-free in retirement.
In traditional accounts, you are contributing money pre-tax, with the advantage that it lowers your taxable income now. That means if you contribute $6,000 to a traditional IRA in 2020 and you don’t have a retirement plan at work, you could lower your taxable income by $6,000. In simple terms, $50,000 of taxable income could then be $44,000. While you do get the tax break today, you will have to pay taxes in the future when you withdraw the money during retirement. The amount you pay will depend on your tax rate at the time.
Understanding the Limits for Roth and Traditional IRAs
Unfortunately, you can’t just stockpile all of your money into an IRA or 401(k) and get the long-term benefits. There are contribution limits you should know about. In 2020 and 2021, you can contribute up to $6,000 to a Roth or traditional IRA. The limit jumps to $7,000 if you’re 50 or older. (The max contribution for a 401(k) is $19,500 in 2021.)
But wait, there’s more! In addition to contribution limits, you might be restricted in taking advantage of the tax benefits. Because Roth IRAs are pre-tax, the restriction is on whether or not you’re allowed to even contribute. For traditional IRAs, the restriction is on being allowed to deduct the contribution from your taxable income. I know this can be a mindbender at first, so don’t get frustrated. Here’s how the limits are enforced:
The amount you’re allowed to contribute to a Roth IRA depends on two big factors: tax filing status (e.g. married filing jointly or single) and income. For example, if you’re single and your adjusted gross income (AGI) is less than $125,000, then you can contribute up to $6,000 each year. For married couples filing jointly, you and your spouse can both contribute up to $6,000 each year as long as your AGI is less than $198,000.
When you’re contributing to a traditional IRA, the amount you’re allowed to deduct on your taxes involves those same factors, plus one additional factor: if you have access to a retirement plan at work. If you’re single, have an AGI of $76,000 or more and have access to a 401(k) at work, then you don’t get any immediate deduction on your taxes for contributing to a Traditional IRA.
If you’re single and aren’t covered by a retirement plan at work, then you can always deduct your traditional IRA contribution.
While this can sound a little overwhelming at first, the IRS makes this information pretty straightforward, or you can always ask an accountant for help.
Does It Matter Which One I Choose?
Ultimately, which retirement vehicle you choose comes down to your future tax bracket and current income.
If you believe you will be in a higher tax bracket when you retire, then a Roth IRA makes sense because you’re paying taxes today at a lower rate. This is also why younger people are generally advised to open Roth IRAs. The prevailing logic is they’re in a lower tax bracket right now than they will be in the future.
However, if you’re sure that in the future you will be at a lower tax bracket and would prefer the tax break today, then it might be wise for you to pick the traditional IRA.
Understanding your options and the pros and cons of retirement accounts can help you invest now and prepare for your future self. Just make sure your money is actually invested and not sitting there in cash! Compound interest isn’t working for you if the money is idle.