IRAs for Beginners
If you’re curious about Roth and Traditional IRAs, this overview can help you understand how they work.
By Tracy Scott
An individual retirement account (IRA) is a type of savings account that can be a great way to plan for future expenses. Due to the tax advantages of IRAs, early and consistent financial contributions are encouraged by most financial planners.
However, understanding how IRAs differ from other savings plans, like an employer-sponsored 401(k), can be challenging. We’re here to help! Here’s a basic introduction to IRAs to help determine which type is most likely to meet your needs now and in the future.
Why consider an IRA?
Financial experts estimate that you’ll need at least 85% of your income to sustain you in retirement. Smart employees contribute as much as they’re allowed through their employer-sponsored retirement plans, but that still may not be enough. Fortunately, you can supplement your retirement savings with an IRA. Money for retirement that’s placed in an IRA not only offers potential tax benefits but provides an opportunity for greater financial returns when compared to a regular savings account. If your employer does not offer a retirement savings plan, start your own with an IRA.
The array of investment options available with IRAs make them attractive for individual taxpayers looking to grow their money faster without paying taxes every step of the way.
Investment options might include, but are not limited to, a mix of stocks, bonds, real estate or mutual funds. Even though funds are not contributed pre-tax via your paycheck, IRA contributions are either tax-deductible or offer a tax-deferred benefit.
You may be able to withdraw funds from an IRA before age 59 ½ for qualified expenses without penalty. Qualified expenses might include, but are not limited to, funds withdrawn to pay for higher education, unreimbursed medical costs or funds used for the purchase of your first home. Early withdrawals from your account that are considered a “qualified expense” are not subject to the 10% early withdrawal tax.
Savers have a choice when selecting the type of IRA that best fits their financial situation: Traditional or Roth. Let’s take a closer look at each one below.
Traditional IRA: Earn now, delay taxes until retirement
With a Traditional IRA, you can put away money for retirement and watch your savings grow, while postponing paying taxes on your earnings. Once you start making withdrawals in retirement, that’s when you’ll pay taxes on your investment gains. Put simply, you can boost earnings now, and pay taxes on them later in retirement.
Benefits of Traditional IRAs
When you make deposits to your IRA, they may count as an itemized deduction on your Federal Income Tax Return. This can help you save money, since itemized deductions help reduce the amount of taxes you’re required to pay each tax year.
Is it for you?
If you (or your spouse) are under age 70 ½ with earned income and your tax rate is expected to be lower during retirement, it might be a good idea to invest in a Traditional IRA. Here’s why. Your income is likely to be higher during your working years, which may place you in a higher tax bracket. If you’re eligible for Traditional IRA-related tax deductions now, you can benefit from a lower tax bill. Then when you reach retirement and are presumably in a lower tax bracket, you’ll pay less in tax on your withdrawals.
While Traditional IRAs offer nice advantages, you’ll need to be cautious about when you withdraw funds. If you are age 59 ½ or older, you’ll want to delay cashing out your IRA to avoid early withdrawal penalties of 10%, unless it’s for qualified expenses such as buying your first home or paying college tuition and fees. Also, keep in mind you are required to start withdrawing money from your account at age 70½.
Kind in mind, Traditional IRAs and Roth IRAs have annual contribution limits, so plan ahead for the year's contributions.
Why traditional IRAs are unique
Investors can convert a Traditional IRA to a Roth IRA where funds can grow tax-free. However, the balance transfer is taxable.
Roth IRA: Pay taxes up-front, watch your earnings grow
A Roth IRA is a retirement account that allows you to boost your earnings with contributions on which you’ve already paid taxes. So, you can withdraw funds tax-free, provided that certain conditions are met.
Benefits of Roth IRAs
Since you’re contributing to your Roth IRA using after-tax dollars, you can grow your money over time, and won’t have to pay taxes on your gains when you make withdrawals. So, if you predict your tax rate might be higher in retirement than it is now, the Roth might be a wise choice.
Is it for you?
If you (or your spouse) are within certain income thresholds, you can contribute regardless of age. Again, you’ll want to consider whether your expected tax rate will be the same or higher during retirement. If so, it might be a good idea to invest in a Roth IRA since you pay taxes on the deposited funds now instead of during retirement.
You can withdraw earnings tax-free and penalty-free anytime, provided that you’ve had your Roth account for at least five years and you’re at least 59 ½ years old. (However, you still may be able to withdraw earnings before you’re 59 ½ if it’s for qualified expenses like those mentioned above.)
Again, keep in mind that Roth IRAs and Traditional IRAs have the same annual contribution limits, as previously noted.
Why it’s unique
- In contrast to a Traditional IRA, which requires withdrawals at age 70 ½, Roth IRA owners are not required to take distributions based on their age. The absence of an age threshold allows savers to continue depositing money into their Roth IRA’s after age 70 ½.
- You have the ability to contribute to your employer-sponsored retirement plan as well as a Roth IRA.
- If your account is at least five years old, withdrawals for qualified education expenses, e.g., college tuition and fees, can be made tax-free.
Coverdell Education Savings Account (CESA)
A Coverdell Education Savings Account CESA isn’t a retirement account, but a way to save for future educational expenses of a designated beneficiary. Instead of placing funds in a regular savings account, CESAs provide a tax-advantaged way to invest in stocks, bonds, mutual funds, and other financial products.
A CESA is not tax-deductible, but distributions are tax-free.
The beneficiary must withdraw the funds by the time he or she reaches age 30 unless they are exempt under the Federal Tax Code.
Why it’s unique
- If the child forgoes college, you can transfer your CESA funds to another family member’s CESA.
- Beneficiaries can have more than one CESA account.
Is it for you?
If you wish to provide financial help with a young family member’s education and your income falls within yearly tax thresholds, then this investment account might be a good option. Use funds invested in the account to cover qualified educational expenses. This account should be paired with other funding sources since annual contribution limits are capped.
Parents, grandparents and even non-family members can contribute funds to a CESA if the child is under the age of 18 or is otherwise exempt. Due to the relatively low annual contribution limits, investors should start investing in a CESA early in the child’s life.