Several IRA (Individual Retirement Arrangements) Types and Which One is the Best for You?
*Note: The basics of retirement are similar in many markets, but this article has content that is more specific to US population.
Life after retirement could be scary if you lack the habit of saving. To get a clear roadmap of how you should be saving, talk to a newly retired person because he has been through both poles, and could help you achieve financial independence after the active working life.
The majority of professionals in the United States choose an IRA when they are working. They do that because they don’t want to worry about their personal finances post-retirement. I’m sure you’ve heard of IRAs, but have you decided on a type? If not, then being your financial advisor (one, whom you don’t pay a dime), I’d like to help you choose.
To make an informed choice, you need to know all IRA types. Traditional IRA is the oldest model, and quite simple too; you keep contributing cash, which starts to grow in a fund. The tax deduction doesn’t apply to the money in the fund until you withdraw it. This way, you can save more money. The tax deduction after the withdrawal of the money is called IRA contribution. If you withdraw the money before you are 59.5 years old, a penalty tax of 10% would be imposed.
The benefit of this model is easy to grasp; you can delay paying taxes on earned income. The same applies to investment. Whatever investment you make, if you contribute to conventional IRA, it won’t be tax deductible. The interests and the dividends, which accrue in the account don’t come under tax deduction either.
Roth IRA is 180° opposite to traditional IRA. In the case of Roth IRA, you pay the tax upfront when you make the contribution. The best part is at the time withdrawing the money, no tax deduction applies. There’s another cherry on the cake; you can withdraw the money even when your age is less than 59.5 years, and there won’t be any penalty tax.
A Roth IRA makes investment earning non-taxable. You can feel free when investing your money in the stock market; even if the return is enormous, it still won’t come under tax deduction. The qualification for Roth IRA depends on income limit. In 2016, the modified adjusted gross income limit for the single applicant will be between $117000 and $132000. If it’s a married couple, the limit will be between $184000 and $194000. People qualified for Roth IRA can have a separate retirement plan sponsored by their employer alongside.
How to choose
Since both types come with advantages (and disadvantages), you need to choose carefully. The rule of thumb is to consider your current tax bracket. Go for a Roth IRA if your current tax bracket is not high enough. On the other hand, if the existing tax bracket is high, but you expect it to reduce in the future, especially when you’ll retire, a traditional IRA would be a good idea.
There are few other considerations, though. One of them is the likelihood of making an investment in the foreseeable future, and the odds of being successful in that. Let’s say a large-scale private firm is all set to file for IPO next year, and you own shares in that company. It’s an investment that could earn you millions. Now if you go for a traditional IRA, you’d have to pay taxes on the investment earning. Hence, if you expect any of your investments to fetch you money in the future, opt for a Roth IRA.
Conversion to Roth IRA
It’s a sheer myth that traditional IRA is not flexible. It gives you the option to move to Roth IRA. A lot of people do this, and you might do the same if you currently have a traditional IRA. But before you do that, there are a few things that you need to consider, so the conversion doesn’t go against your interests.
The benefit of the conversion is it exempts your heirs from federal income tax for any withdrawal if they leave the account open for a minimum period of five years. Besides, you avail all advantages of Roth IRA and get an exemption from tax. However, if you are dead sure that your tax bracket will go down in the future, then don’t go for it. Another thing to consider is the source of the money, which you’ll pay for the conversion because if you take money from IRA, less money will accumulate.
Take a wise decision
You must take a wise and informed decision. Consider all the points, discussed here in this article, and if needed, consult with an expert. The more deep is your understanding, the better is the odds of success.
What do you think of the ideas shared here about IRA? Do you want to add anything of your own? Let us know in the comment section.
Tina Roth is a personal finance blogger and writer. In addition to being the solo writer at her Personal Finance Blog, you can find her work on many other online finance portals.