Simply put, an IRA (Individual Retirement Account) is a retirement savings tool that allows you to save in a tax-beneficial way, maximizing your impact. Rather than an employer-sponsored 401k, IRAs allow individuals to save for retirement on their own. IRAs can also be used to supplement a 401k once you’ve maxed out your annual contribution limits. However this savings tool fits into your strategy, you can get the most out of your IRA by understanding it on a deeper level.
IRAs can grow tax-free or be tax-deferred, depending on the type of account. So, it’s not only important that you decide if an IRA is right for you but also what type of IRA will be most beneficial to your financial strategy.
In this article, we’ll share a simple explanation of the three types of IRAs available, what makes them different, and how you can choose which one is best for you.
Three Types of IRAs
1. Traditional IRA—Eligible contributions that you make to this account can be deducted from your taxable income. Your earnings on this money can also grow on a tax-deferred basis until you were to withdraw the money at retirement.
2. Roth IRA—Your contributions are made after taxes, meaning that you contribute money that you’ve already paid taxes on. This way, your money could grow tax-free, and you will not pay taxes on that money upon withdrawal.
3. Rollover IRA—Your contributions are rolled over from an employer-sponsored plan (i.e., a 401k or a 403b).
Why Might You Choose an IRA?
You might choose to use an IRA account if:
- Your employer does not offer a 401k
- You want a wider range of investment options
- You want to save for retirement after maxing out your 401k, or
- You want tax-deferred or tax-free growth.
If you do choose an IRA, though, you may need help deciding between a traditional or a Roth IRA. They each have their benefits, but it’s likely that one fits into your financial strategy better than the other.
Traditional IRA or Roth IRA: How to Choose?
You might choose a traditional IRA if you think that you will be in a lower tax bracket during retirement. As you won’t be paying taxes on the money until then, if you expect to be in a lower bracket, you would ultimately pay less in taxes by waiting. With a traditional IRA, you are accepting tax benefits now (deductible contributions), knowing that you will pay taxes on the funds later. Many choose this option because they believe they will be in a lower tax bracket once they are no longer receiving their day-job income.
On the other hand, you might choose a Roth IRA if you feel that you will be in the same, or higher, tax bracket post-retirement. With this option, you take care of your tax obligations sooner rather than later. Roth IRAs also provide the account holder with more flexibility, allowing you to access your contributions without incurring a penalty; however, it’s worth noting that you will not be able to withdraw the earnings without a penalty. If you feel more comfortable having easy access to this money, you might choose a Roth IRA; however, it may go without saying that it’s best to not touch your retirement funds until you retire.
After reading these explanations, you might be thinking, “but how will I know what tax bracket I’ll be in when I retire?” It is difficult to know, yes, as we can’t see into the future. So, you would go on your best guess determined by your long-term financial strategy and your post-retirement expectations. If you don’t have the information necessary to make that guess, it is wise to discuss this choice with your financial advisor. They can help you determine what makes the most sense with your strategy. Keep in mind, too, that if you have a 401k with your employer that is already tax-deferred, you might consider a Roth IRA that is tax-free at withdrawal so that you can take advantage of both.
Need help choosing your IRA?
Our team of retirement planning experts can help you determine the IRA that will maximize your financial plan. Contact us today to learn how we can guide you to your dream retirement.
