A Quick Example
Let me first get your attention by using a simple example. If you are 30 years old with $0 in your retirement account, and you contribute $5,500 annually at a 7% return, how much money will you have when you hit retirement when you are 65? Using Bankrate’s Roth IRA calculator we can see below that your account would balloon to $813K.
Our principal contributions (the money you put in every month) itself is $192k, which helps us yield another $612k through growth.The monthly contribution comes down to about $458 every month. That’s not so bad.
You probably have noticed but the talk about retirement planning is around us perennially. It’s nothing new as we are constantly reminded how underprepared we are on our retirement savings. Radio talk show hosts, webinars on YouTube, Finance experts on the news, the big brokerage firms and their advertising…all of them telling us the same thing: Open an IRA today and start contributing to it.
The IRA, pronounced eye-ruh, stands for Individual Retirement Account which is a special type of account that anyone can open for themselves. The ultimate purpose of this account is to help you live a cushier life after you have retired from your livelihood. You see, we spend on average 40 some years working from adolescence to retirement. We are focused on making money, spending money on ourselves and sometimes saving it if we are smart. But what about saving after you have retired from your livelihood? What about saving for when you need the money say 40 years from now? We will never save for retirement unless we have a structured way of approaching this problem.
So how does the IRA help us live a cushier life in our post-retirement world? Well, it’s an account that you create and fund on a monthly basis. If you reach into that account for a withdrawal you could get taxed and penalized (There’s some minutiae around this which we will touch ahead). An IRA will help you allocate (set aside) money early on. Basically every month, out of your paycheck, you will fund your IRA. You can choose to invest your paycheck in stocks, bonds, and other instruments and you can open one at any bank or online brokerage.
Let’s peel back a layer and get deeper into the details to see how this whole retirement planning thing works.
IRA’s generally come in two different flavors….
Traditional IRA vs Roth IRA
In a Traditional IRA you set aside a few bucks every month into your IRA account. One of the biggest benefits of doing this is that you can deduct this amount from your personal income, which means that your taxable income is reduced and you will ultimately pay less taxes.That’s definitely great. Your money will grow, year after year, and you don’t have to worry about paying capital gains on these when you do your yearly taxes. But….once you hit retirement age and withdraw the money is when you will be hit with taxes. So essentially you see your money grow tax free over the years, but you pay taxes at the end when you withdraw.
In a Roth IRA you also set aside a few bucks every month and deposit it into your Roth IRA. However, you can’t deduct these contributions from your taxable income like you did with the Traditional IRA. And so when you finally withdraw funds from your Roth you can do so without having to be pay tax. Why? Because your monthly contributions to your Roth IRA were taxed as you made the contributions. Pay taxes now on your monthly contributions and withdraw tax free later without worry. This can be good because say, 40 years from now when you retire, the taxes may be super high. That way you can protect yourself against crazy high taxes in the future. Also it is generally easier to pay taxes when you have a job rather than paying taxes when you are retired. Another reason to go for the Roth.
The Devil Is In The Details
There are a myriad of detailed rules on the Traditional and Roth IRA accounts. They have to do with your age, the age of the account, and qualifying withdrawals you can make without penalty. We are going to keep it very high level so you can can focus on understanding the concept.
If you are under 50 you can contribute a maximum of $6,000 annually in your Roth or Traditional IRA. If you are over 70 you can contribute $7,000 annually. If you are married filing jointly you guys can’t make more than $203K, and if you are single the cutoff is $137K. If you are 59.5 yrs old and haven’t had your Roth opened for at least 5 years then you will owe taxes and a 10% penalty if you withdraw.
Regarding withdrawals from a Roth IRA: If you are at least 59.5 years old and have had the account for 5 years, you can withdraw unlimited without penalty or tax. You are allowed to take out $10k as a first time home buyer without penalty (taxes still apply).
Reasons To Open An IRA
The number one reason anyone opens an IRA is so that your money can grow. We all know that long term growth is really bolstered by big contributions at an earlier age. The goal is to have a nice pile of cash waiting to you by the time you hit retirement age.
Should You Open An IRA?
That’s the big question. We will reserve another separate article to answer just this question. But there’s no doubt that the Roth IRA seems to be a better deal than the Traditional IRA. You can grow your money in a separate account and not be tempted to touch it. Paying taxes in the beginning also seems to be beneficial. This is definitely a step towards creating a cushy post-retirement life.