The subject of retirement can be simultaneously stressful and fascinating. Historically, Americans relied on three sources of income at retirement: (1) a pension, (2) social security, and (3) personal savings. Most private businesses have eliminated pensions. If you have one, consider yourself blessed. Social security began as a voluntary option which allowed the federal government to compete in the marketplace as caretaker of the non-working elderly. Eventually, social security became obligatory and it prospered under the baby boomers as the aging generation actually engendered enough children to increase the pool of people paying into the national plan. Now, however, the American birth rate is in decline, the social security fund is often used for other governmental purposes, and there is a real risk that the rising generation will not receive adequate social security payments to actually survive while not working during their golden years. Consequently, only one leg of the three-leg retirement savings stool will likely be available for future Americans: their own personal savings.
There are a few options to save for retirement: employer sponsored plans or individual plans. Employers may sponsor retirement accounts such as 401(k) or 403(b) accounts and provide a matching contribution which is a significant benefit over time. Contribution limits are generally higher on a per year basis in these plans. Keep in mind that there are restrictions on what type of investments you may access and when and how you access the funds in the event of a hardship. Meanwhile, individual plans such as an Individual Retirement Account (IRA) offer anyone a viable way to save for retirement. IRAs allow for near limitless investment options, however, the contribution limits are much smaller than employer sponsored plans.
Historically, IRAs only allowed individuals to defer taxes that would otherwise be assessed in the year that the income was earned for the purpose of accruing compounded interest over time. For example, if you had to pay $1,000.00 this year in taxes you would not only lose the $1,000.00, but also all the interest that would compound on that money over then next 10, 20, 30, or 40 years. So, if you took that $1,000.00 and invested it for 30 years and received 6% interest per year then you would have $2,800.00 at the end of the 30 year period. So, the opportunity lost, or in accounting terms—opportunity cost—of paying $1,000.00 in taxes today is a loss of $1,800.00 in compounded interest over the next 30 years! This principle is based on the time value of money and losing money over long periods of time is very painful. This is the central principle underlying a traditional IRA.
A traditional IRA is a retirement account that allows you to assume the investment risk on your own money at the government’s expense. You get to defer paying taxes as long as the money remains in a traditional IRA. The minute you decide to take any money out of the IRA, you will be taxed on it as though it were regular income. In addition, if you withdraw the money without a qualifying purpose before age 59½, you may be subject to a 10% penalty.
In the example above you get to take $1,000.00 today that would have otherwise gone to pay Uncle Sam. You get to choose how to invest that money. You can choose from a wide variety of options: cash reserves, stocks, bonds, money markets, exchange traded funds, and in certain circumstances even very risky investments like hedge funds. No employer gets to tell you what you can or can’t invest in! You can give the money to the many investors who will happily take it, but here’s the important caveat: with great power to invest comes great responsibility to educate yourself, monitor the market, and manage your hard earned money. If you choose to invest all your money in the hot stock of the day, no one will stop you. Go right ahead, because you have assumed 100% of the investment risk associated with the account. If the company’s stock only goes up over time, you have the possibility to make more than 100 times the amount of your investment! If, however, the company goes bankrupt, your hard earned retirement money along with any hope of compounded interest goes along with it. Now let’s discuss the general distinctions between this traditional IRA and the more recently created Roth IRA.
Benefits of a Traditional IRA
Pre-tax contributions. That is the key benefit of a traditional IRA. That means that you get to invest money that would otherwise be paid to the federal government via a tax deduction and not pay any taxes on the money or earnings from the investment until you withdraw the money. Any money withdrawn will be taxable at your then current tax bracket. Essentially, the money will be treated as though it were paid to you by an employer. In addition, there is no eligibility limit as to who can open an IRA account, although there is a smaller annual contribution limit than with an employer sponsored retirement plan.
Downsides of a Traditional IRA
Any withdrawal prior to age 59½ is generally subject to a 10% penalty. After age 70½ you must begin taking required minimum distributions. Plus, both the money contributed and the earnings are all taxable subject to your existing tax bracket at the time of withdrawal. If you are still working after age 59½, make $60,000.00 a year, and withdraw $30,000.00 from your Traditional IRA then you will be in a tax bracket encompassing an annual income of $90,000.00. That withdrawal could put you into a higher tax bracket and increase the amount of taxes payable to the government. Beginning in 2019, tax brackets will range from 10% to 37%. So plan your withdrawals carefully.
A Roth IRA allows you to contribute a limited amount of money to your retirement generally with all the same investment options and investment risk contained within a Traditional IRA. The key distinction is how earnings are treated for tax purposes upon withdrawal.
Benefits of a Roth IRA
Roth IRA contributions are made after taxes have already been paid on the money being invested. As a benefit, the government does not require you to pay taxes on any of the earnings made within a Roth IRA at the time of withdrawal. For example, if you invest $10,000.00 into a Roth IRA at the age of 30 and the investment grows to $100,000.00 by age 70, then you get to withdraw the full $100,000.00 as “after-tax” income. No need to pay taxes on the earnings even if you have a high tax bracket at the time of withdrawal. That is the benefit of the Roth IRA. Keep in mind that a penalty may be applied for early withdrawals absent a qualified safe harbor exemption like disability. Also, if you need to withdraw money prior to age 59½, you will need to keep a record of the contributions and the earnings. Contributions are accessible at all times, while earnings may only avoid taxation if the contribution has been invested for 5 years. In addition, there is no age limit to begin contributing to a Roth IRA. So, even if you have surpassed the average retirement age of 55, you are still eligible to make contributions.
Downsides of a Roth IRA
There is no immediate tax benefit to saving for retirement. If you contribute $5,000.00 today then you are taxed now at your current tax bracket for the entire amount. Plus, there is no tax benefit on the earnings unless the contributions are kept in the Roth IRA for at least 5 years even if you are older than 59½.
Furthermore, there are limits on who may contribute to a Roth IRA based on one’s current annual income. In 2018, if you are married filing jointly and make $189,000.00 or more then there are additional restrictions as to how much money you may contribute per year to the Roth IRA. If you are married filing jointly and make $200,000.00 or more per year, then you may not contribute to a Roth IRA.
When selecting a particular retirement account, there are many factors that should be considered before making a final decision. Just like every human, each person’s financial story is different. The bottom line: do not sign up for a specific retirement account without first thoroughly researching your options.
When planning for retirement, remember to consider the role of credit in your golden years. It may be harder to qualify for a desired loan or a revolving credit account once you are no longer working full time. So, remember to monitor your credit and keep your credit report as clean as possible. If you are interested in learning more about how to repair your credit in preparation for retirement, please contact Lexington Law today.
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