A few months back we discussed saving for retirement through a 401k (and a few months before that, we talked about why saving why retirement as early as possible is a good idea!). I promised to address the other way most people save for retirement – IRAs – and now I’m here to deliver! Question and answer seemed to work last time, so we’ll try it again :)
What is an IRA?
An IRA, or Individual Retirement Account, allows you to save money for retirement with tax advantages. The account is held at a financial institution, not through your employer. There are two main types of IRAs – Traditional and Roth – and they have different advantages.
What is a Traditional IRA?
In a Traditional IRA, you’re able to deduct your yearly contribution from your taxable income (reducing the amount of money you have to pay taxes on – yahoo!). Ideally, the money will build up over time, and then in retirement, you’ll pay income taxes on it when you take it out. Many people find themselves in a lower tax bracket when they retire, since they’re not making a salary, so their withdrawals might be taxed at a lower rate than it would have been earlier in life. Tax benefits today, taxes when you withdraw.
What is a Roth IRA?
In a Roth IRA, you pay tax on your income as usual, then contribute to your IRA. Then, your money grows tax-free, and you can withdraw it tax-free in retirement (assuming you retire after age 59 1/2). Taxes when you contribute, no taxes when you withdraw.
Why save in an IRA instead of another type of account?
Great question! First, if your employer offers a 401k, and especially if they offer a match, max out your match first! (Don’t leave money on the table!) But, don’t stop there :) Since experts estimate that you might need up to 85% of your pre-retirement income in retirement, you might not be able to accumulate enough through just a 401k (there are limits on the amount you can contribute per year).
Also, most IRAs offer a wider range of investment choices (stocks, different funds, etc.) than most 401ks, giving you more flexibility. And of course, the investment options you get with an IRA can earn you much more than a savings account, a CD, or other taxable accounts.
How much should I contribute?
Well hold your horses – first you have to have earned income. (I know that seems obvious, but I do have lots of students reading!) For 2014, the maximum amount you can contribute is $5,500 if you’re under 50 (assuming you’ve made at least $5,500 that year). There is no minimum. $5k sound like a lot? John and I love Megan McArdle, and she recommends saving 15% of your gross income for retirement. On the other hand, note that there are some contribution limits based on income – Fidelity explains them here.
How do I get started?
Yay for you! Many financial institutions offer IRAs – we have used Fidelity and Scottrade in the past, and I would recommend both. Most allow you to sign up and make contributions online. A tip – once you have everything ready to go, set up an automatic monthly draft so you don’t have to think about making a contribution each month!
As usual, this is a great time for me to remind you that I am neither a financial planner nor a tax adviser, and that this is a very basic guide to IRAs. Retirement savings are VITAL but can be complicated, so I highly encourage you to seek assistance along the way. As a bonus, many companies, like Fidelity, offer really amazing guidance over the phone, at no charge!
You know why it’s fun to talk about IRAs right now? If you haven’t yet filed your taxes, you can still make a contribution for 2013!
Do you save for retirement with an IRA? Did you choose Traditional or Roth? I’d love to hear!