Like it or not, one day we are all going to be too old to work or want to work, and will want to retire. The scary part is that not everyone is entitled to a comfy retirement. A comfortable retirement requires a lot of strategic planning of savings and making wise financial decisions while you are young.
To begin, we have a chart from Money Under 30 that can help draw your conclusion of what retirement fund may be the best option for you to take.
As you can see, both funds are excellent retirement accounts, but they are for different people with different incomes. To determine what retirement account works best for your income, take account the following characteristics of the two accounts.
1. The Amount You Contribute
Both Traditional IRAs and Roth IRAs have the same contribution amount per tax year—$5,500 (based on the 2018 guidelines). This limit jumps to $6,500 if you’re over 50 years old (called a ‘catch-up’ contribution).
Since these two have the same limits on contribution, it is a good option for anyone when it comes to the amount you contribute. But sit tight, there are more characteristics to help you differentiate between the two.
2. The Different Age Restrictions
Surprisingly, not all retirement accounts can allow you to contribute regardless of your age. Traditional IRAs have an age restriction that once you are 70.5 years old, you can no longer contribute funds to a Traditional IRA. This is a restrictive and limits you as many people are still working well past 70 these days. A Roth IRA, on the other hand, does not have any age restriction—so you can contribute to one as long as you’d like. It’s clear that when it comes to depositing at any age, the Roth IRA is the way to go, because we can never plan how old we will be, and how long we are going to work. We can anticipate, but you just do not know what lies ahead, so it’s much more flexible to use a Roth IRA without a silly age limitation to worry about.
3. There Are Limitations in Income Contributions
If you’re filing single a Roth IRA, you must have a modified adjusted gross income of less than $135,000 per year. Modified adjusted gross income (MAGI) represents your adjusted gross income (AGI), with the addition of certain deductions. Married couples who file jointly can have a MAGI up to $199,000 if they’d like to contribute to a Roth IRA. These numbers are current as of the 2018 tax year but can change based on the year.
A Traditional IRA does not come with income restrictions—so you can contribute to one regardless of how much you make per year. This makes for a sound option for those who are making too much money (lucky!) to contribute to a Roth IRA.
There are, however, limits by which you stop getting tax deductions if you’re already being covered by a retirement plan at your job. If this is the case, once you pass a certain threshold, you either get a partial deduction or no deduction at all. For example, married couples filing jointly and making over $99,000 per year would get no deduction.
4. Tax Deductions are Different For Each
One of the cushiest benefits of having a Roth IRA is the tax-free withdrawals. More often than not, any earnings and withdrawals you make in retirement won’t be hit with income taxes. This is because the money you deposit into a Roth IRA has already been taxed.
Traditional IRAs also enjoy tax benefits because your contributions to a Traditional IRA are tax-deductible on both the federal and state level. This means you get a tax break during that tax year, but in turn you will owe income tax on the withdrawals when you take money out in retirement. All in all, both accounts are the same in the regard of tax benefits.
5. Differences in Withdrawals
This is definitely where the differences between the two retirement accounts lie. With a Roth IRA, you can withdraw your money (tax-free) at any time after 59.5 years old without any charges as long as that money has been in the account for at least five years. If you don’t need the money, you can let it sit there and grow. And since there are no age restrictions, you can continue to contribute.
Traditional IRAs, on the other hand, require you to take money out once you hit 70 ½ years of age. This amount is called the required minimum distribution, or RMD. The challenge is that these withdrawals are not only mandatory, but they’re taxable. So if you reach age 70 ½ and you have no need for the money, you’re stuck and you still have to take it out and pay the taxes.
6. Backdoor Roth IRA
However, if you are fortunate enough to make too much income to contribute to a Roth IRA, you aren’t completely excluded. There is an option of a Backdoor Roth IRA. A Backdoor Roth IRA is a method that taxpayers can use to place retirement savings in a Roth IRA, even if their income is higher than the maximum the IRS allows for regular Roth IRA contributions. Backdoor Roth IRA is an informal name for a complicated, IRS-sanctioned method for high-income taxpayers to put money in a Roth; it is not the formal name for an official type of retirement account (via Investopedia).
The Backdoor Roth IRA is the most ideal retirement account, but if you are not lucky enough to just have too much money, a Roth IRA is typically the best option to take for any person looking to save up for retirement.
Time is Money!
If you haven’t saved for Retirement yet, for whatever reason, it is highly recommended to start now than later. The value of time and accrued interest over that time is invaluable, and unable to be matched in the long run. For example, if you saved a little in a Roth IRA from age 18 to 50, the interest alone would surpass any large amounts you would put into your retirement account from age 40-50 when you probably need more money to take care of children, parents, etc. Our recommendation is to take full advantage of a Roth IRA. In a fiscally perfect world, you are advised to max out your 401k first since it reduces your taxable income, and then use all of your extra green and put that toward maxing out an IRA.
Need an example? Check out this example of the magic of compounded interest:
Assume you contribute $3,000 to your Roth IRA for 20 years, for a total contribution of $60,000. In addition to your contributions, your account earns $5,000 in interest, giving you a total balance of $65,000. To ramp up your savings, you decide to invest in a mutual fund that yields 8% interest annually.
Even if you stop contributing to your account after the 20th year, you earn 8% on the full $65,000 in the 21st year. You earn $4,800 in simple interest and $400 in compound interest, increasing your account balance to $65,000 * 1.08, or $70,200.
The second year after your last contribution, you continue to earn 8% on the sum of your contributions and previous earnings, yielding another $70,200 * 0.08, or $5,616, in total interest. Your balance is now $75,816. You gained nearly $11,000 in just two years without making any additional contributions.
In the third year, you earn $6,065, increasing your balance to $81,881. If you fast forward another five years, your account earns another $38,429 in interest, and your total balance is $120,310. Without contributing anything further to your account, your Roth IRA has nearly doubled in the past eight years through the power of compound interest.
Ready to work with a professional to get your gold for retirement so you can coast into your golden years? Contact Lassise Financial Coaching today for a free 30 minute consultation. Let’s get you ready for Retirement today by clicking the button below!free