An IRA is an individual retirement account. At some point you will want to retire, right? With the way that Social Security is going these days, there’s no guarantee that the government will be able to manage the payments needed by the time you retire. The good news is, there is an option that you can use to start saving for retirement now. With an individual retirement account, or IRA, you can put money away for retirement. There are two main IRAs, a traditional IRA and a Roth IRA. The only difference between the two are the differences in tax rules.
Two Types of Individual Retirement Accounts
A traditional individual retirement account is an account that you can put money in on a pre-tax basis. Whatever is deposited into this account has taxes deferred until withdrawal. So you don’t have to pay taxes now, but you will have to pay taxes once you decide to withdraw, either early or at the age of retirement.
In comparison, the money that you put into a Roth IRA goes in on an after-tax basis. These are funds that you have already paid taxes on. Once you withdraw from the account, as long as you stay within the rules, you do not have to pay taxes. There are a few qualifying events that will allow you to withdraw before retirement without paying taxes. IRS.gov has the details and most updated specifics; but here are the general guidelines. If your Roth has been established for 5 years or more, you can withdraw any deposit free of tax penalties. First time home buyers can use Roth funds to purchase a home. There are a few other ways to qualify a tax penalty free withdrawal and you can find those at IRS.gov.
How to Decide if a Roth is Right for You
A Roth is beneficial if you are very young and/or in a very low tax bracket and you expect your tax bracket to rise in the future. Because you are using after-tax funds, when it is time for you to withdraw, everything you’ve put in plus all of your gains are yours to take tax free. Imagine if you opened your very first Roth at the age of 18. If you are maxing out contributions, meaning, you are depositing the maximum that the government allows, you could have 15,000 in three years. Even if you stop putting more money in, by the time you retire at the age of 72, your Roth could be over 472,000 dollars if it were to grow at 7% compounded yearly. And everything in excess of 15k is yours, tax-free. You do not have to pay taxes on the gains in a Roth. Interested in a Roth?
How to Earn 7% with a Roth
I’m sure by now you are wondering, how the heck do I make 7% consistently, year in, year out? That’s a good question. It’s pretty easy for me to calculate some numbers that give you half a million in 50 years, but how does that work in real life? Well, 7% is not so unattainable. It just depends on how hard you are willing to work for it. Do you have the time to research stocks and manage your own portfolio? Maybe not. Most people don’t. If you stick to a passive investing strategy such as matching an index, you could possibly earn 7% without all of the work. But how will you go about matching an index. Are you going to buy each individual stock? Most likely not. And that’s where mutual funds come in. Mutual funds are portfolios managed by professional managers. They have the time to do the research so you don’t have to do it. In a future post I will go into more detail on mutual funds and how to use them in a portfolio.
Have you started planning for retirement?
This is a staff post from LaTisha at Financial Success for Young Adults where she writes about budgeting for beginners and tips for successful investing. Visit YoungAdultFinances.com to see more from her.