Retirement Planning Series, Part II
In our previous newsletter, we continued the Retirement Planning section of our financial literacy series by discussing 401(k). Today, we will delve into the topic of Individual Retirement Accounts, or IRAs. While 401(k) has become the prominent way to save for retirement through your employer, IRAs remain an effective way to save for retirement outside of your employer.
There are two major types of IRAs that individuals can consider: traditional IRAs and Roth IRAs. IRAs are personal retirement savings accounts in which you are able to contribute and invest earned income for retirement. While a 401(k) is an account that is sponsored through your employer, your IRA is personal to you. Anyone with earned income can open an IRA through either a bank or one of the major brokerage firms.
The main benefit to saving for retirement in an IRA versus a typical brokerage investment account is the fact that IRAs are tax-advantaged accounts, meaning that there is a type of tax benefit related to using either of them. In a traditional IRA, you are able to contribute earned income on a pre-tax basis, meaning that your investments are allowed to grow with taxes deferred until you begin withdrawing from your account in retirement. On the other hand, Roth IRAs are funded with after-tax dollars, meaning that withdrawals in retirement are tax-free.
While employer-sponsored retirement accounts generally limit your investment options to an investment lineup, both traditional IRAs and Roth IRAs typically allow more freedom to invest in individual stocks, bonds, mutual funds, ETFs, and more. Having access to a wide range of investment choices can make IRAs an attractive option for investors.
While there are notable tax benefits and a wide range of investment options available, there are some restrictions to consider with IRAs. The first type of restriction to consider with IRAs is their contribution limits. In 2023, the annual contribution limit for both traditional IRAs and Roth IRAs is $6,500 ($7,000 beginning in 2024). For context, the annual contribution limit for 401(k) in 2023 is $22,500 ($23,000 in 2024). However, if you are 50 or older, you can contribute an additional $1,000 annually to your IRA.
Another type of restriction with IRAs has to do specifically with Roth IRAs. Due to the significant tax advantages that they offer, Roth IRAs have an income limit. The ability to invest in a Roth IRA is only available to those who either made less than $153,000 for single tax filers or less than $228,000 for those married and filing jointly in 2023. If you make more than these thresholds, you will still have access to a traditional IRA and its tax-deferred status.
Finally, another restriction investors need to consider with IRAs is their withdrawal rules. While there are some exceptions (first-time homebuyers, education costs, etc.) investors who have an IRA must wait until age 59 ½ to withdraw their funds penalty-free. However, investors who have a Roth IRA are able to withdraw any money they have contributed at any time without issue, so long as they don’t withdraw any earnings. To better illustrate this point, imagine you invested $1,000 in a Roth IRA and your investment grew to $2,500. In a Roth IRA, you would be able to withdraw that original $1,000 without issue due to it already being aŌer-tax earned income; if you were to withdraw any of the additional $1,500 in investment earnings, you would trigger tax implications and a penalty.
One final aspect of IRAs to consider is which type of IRA to choose. While it’s impossible to know what tax rates will look like in the future, there is a general rule of thumb. Investors who believe they are currently in a higher tax bracket than they expect to be in when they reƟre should consider a traditional IRA for its tax-deferred status, whereas investors who believe they are currently not in their highest earning years should consider a Roth IRA so that they can pay the taxes today while they are in a lower tax bracket.
While 401(k) allows investors to save for retirement through their employer, IRAs allow investors to save for retirement outside of their employer. IRAs offer tax advantages for both lower-earning investors and investors who are in the peak of their career. By allowing a broad range of investment choices, IRAs provide an additional layer of customization that is typically not found in employer-sponsored plans. With pensions continuing to be phased out, it is important for investors to take advantage of both employer-sponsored plans and individual retirement accounts to save their retirement.
