For many American workers, employer-sponsored retirement plans are valuable options in saving money for the future. While it is true that in general, people with access to such plans don’t take full advantage of them, employer-sponsored 401(k) plans remain a popular retirement asset vehicle.
What about workers who don’t have access to employer-sponsored 401(k) plans? Saving for retirement becomes a bit more difficult – workers have to find viable alternatives in order to build retirement savings. Of the alternatives available, perhaps the most popular are Individual Retirement Account (IRAs).
What are IRAs?
An Individual Retirement Account (IRA), sometimes referred to as an Individual Retirement Arrangement, is basically a savings account where workers can contribute money for the purposes of retirement. There are two major types of IRA, the Traditional IRA and the Roth IRA. Each has their own set of strengths and weaknesses, but both represent great alternatives to employer-sponsored retirement plans.
A Traditional IRA is a brokerage or bank account in which employees contribute a portion of their annual earnings to save for retirement. People with a Traditional IRA may make contributions up until the age of 70 ½, and there are no limits as to how much a person can contribute to the plan.
In a Roth IRA, the basic structure is the same; account holders make contributions to a brokerage or bank account for retirement purposes. The major difference is that a person’s income determines the maximum annual contribution allowed by regulations. Currently, you may contribute up to $5,550 per year to the Roth plan unless you are at least 50 years of age. Those over 50 may contribute up to $6,500 per year.
What are the Differences between Roth and Traditional IRAs?
On their face, IRAs seem very similar, and in many ways, they are. Both serve to help people save for retirement when they may not have access to an employer-funded plan. There are several important differences, however, and each plan has its own advantages and disadvantages.
The most important difference between Roth and Traditional IRAs is their taxing structure:
- A Roth IRA is designed so that any withdrawals taken in retirement are tax-free.
- A Traditional IRA’s contributions are tax-deductible, but retirement withdrawals are considered income, so they are taxed.
In other words, Traditional IRA holders pay taxes in retirement, while Roth IRA holders pay taxes up front as they contribute to the plan. In each case, however, both plans offer tax-free investment growth; any earnings in the plans grow without a tax penalty.
Another aspect to consider when choosing between IRAs is in distributions after retirement. Roth IRA holders are under no obligation to make withdrawals once they retire, while those with a Traditional IRA are required by regulation to take distributions starting at age 70 ½. For those plans, there is a Required Minimum Distribution (RMD), set that way to deplete any savings in the account over the remainder of the account holder’s life.
The final major difference between IRA plans revolve around penalties for early withdrawal:
- In a Traditional IRA, there may be as high as a 10% early withdrawal penalty assessed if you take distributions before the age of 59 ½.
- Roth IRA holders who make withdrawals before the age of 59 ½ may be subject to taxes on the distributions as well as a tax penalty of up to 10%. The benefit here is that contributions to the Roth may be withdrawn at any time without penalty; the tax penalties only apply to earnings withdrawn early.
Where both plans are similar is that regulations allow for an early withdrawal of up to $10,000 without penalty if that money is used to purchase, build, or rebuild a first-time home. If you are married and your spouse also qualifies for a first-time home purchase or build, he or she may also make a $10,000 withdrawal without penalty. There are other scenarios where early withdrawals may be taken without penalty, such as for certain medical-related expenses or in situations where you have inherited an IRA from a parent or spouse. For specific questions about how these plans work, it is critical to get the advice of a retirement planning professional.
Which Plan is Right for Me?
When faced with the choice between a Traditional or Roth IRA, many workers wonder which plan is right for their retirement needs. Retirement planning is filled with complex regulations and considerations; a retirement planning specialist can help you determine which plan to choose for your unique needs.
In general. However, young employees are better off selecting a Roth plan for retirement. Younger people do not have to worry as much about income limits; they may not make as much money as older, more experienced workers. Plus, growth over a 30- to 40-year career helps ensure that your retirement savings are sufficient for your needs once you stop working.
A Traditional IRA has no limits based on income, so these remain a smarter choice for employees earning high salaries.
Considering the tax benefits of each plan is an important step. If you prefer to get a tax break right away, a Traditional IRA is a preferred choice. Those who wish to avoid paying income taxes in retirement should go for the Roth plan instead.
Still confused? It is possible for one person to hold both a Roth and a Traditional IRA plan and contribute to both during his or her working years. This can provide tax breaks now and in the future when you are retired. Provided you adhere to the contribution limits imposed by the plans, you can be sure of having enough money to retire comfortably.
Retirement Planning is Filled with Challenges
Employees who do not have access to an employer-sponsored or funded plan like a 401(k) or a pension do have options when it comes to planning for retirement. IRAs are a great alternative to these employer plans. To determine which is best for your current work history, your tax bracket, and your plans for the future, seeking the advice of a retirement planning professional is the smartest move you can make. He or she can help you find the right plan for your specific needs and goals, helping you to save money for that day when you can finally retire from your job.