4 Factors to Help You Decide Which IRA Account to Open
The Individual Retirement Plan is one of the most effective ways to save for your retirement. These accounts are quick to set up, have low fees, and are convenient because they aren’t connected to an employer. You can open an IRA at any time versus a work plan like a 401(k), which you can only use if your company offers one.
Most importantly, IRAs come with a few extremely helpful tax benefits that let you get more out of your investments so you’ll have more money in retirement. Your actual tax benefit depends on the type of account you open up. There are two kinds of IRAs: a Roth IRA and Traditional IRA. The best IRA accounts for your situation come down to a the following four factors. Learn which account is best for your future.
Factor #1 – Age
The main difference between the Traditional and the Roth IRA is when they deliver their tax savings. We cover this topic more extensively here, but a quick recap is that the Traditional IRA lowers your taxes today while the Roth IRA saves its tax benefit for retirement.
With that difference in mind, you can analyze your personal situation to figure out the best IRA accounts for your needs. One of the factors you should consider is your age. Generally, the younger you are, the more it makes sense to invest in a Roth IRA over a Traditional IRA. This is because you have more time to invest your money which means you’ll have a larger benefit in retirement than an older investor.
For example, Susan is 20 and Joe is 40 and they both want to invest $5,000 in an IRA. They will earn 7 percent a year on their investment and want to take the money out when they turn 60. In 20 years, Joe’s investment will grow to about $19,000. With the Traditional IRA, he’s using his tax deduction on $5,000 while with the Roth he’s saving taxes on the $14,000 of future investment income. That’s a close decision.
Since Susan has much longer to invest, her money will grow by much more. In 40 years, her $5,000 will turn into nearly $75,000. Now, the tradeoff is saving taxes on $5,000 today versus on $70,000 in the future, so the Roth looks much more appealing.
Factor #2 – Income
Your income is also an important factor in deciding between the Traditional and Roth IRA. The more money you make per year, the more it makes sense to use a Traditional IRA. That’s because if you’re in a higher tax bracket, you’ll save more in taxes from the Traditional IRA tax deduction compared to someone in a lower tax bracket. If you’re single and making $30,000 a year, putting you in the 15 percent tax bracket, you save only 15 cents in taxes for every dollar added to a Traditional IRA.
If you’re single and making $100,000 a year, which puts you in the 28 percent tax bracket, you save nearly twice as much in taxes. Now you save 28 cents for every dollar added to a Traditional IRA.
Depending on how much you earn, you might not have a choice in this decision because the Roth IRA has an income limit for eligibility. As of 2014, you can’t use a Roth IRA if you are single and earn more than $129,000 or are married and earn more $191,000 as a couple.
Factor #3 – Access to money
Is there a chance you might need the money in your IRA before you reach retirement? Since the IRA is a retirement plan, you’re supposed to keep your money in the account until you turn 59 ½. If you take money out before then, you’re can, but you could owe income tax plus an extra 10 percent penalty on the withdrawal. Now, there are a few special situations when you avoid the penalty, like if you become disabled or use the money for excess medical bills. If you make a withdrawal for something other than these situations though, you’ll owe the penalty.
Despite these restrictions, the Roth IRA still gives you some access to your money. The taxes and penalty only apply to pre-tax income in your IRA. Since you don’t get a tax deduction for your Roth IRA, your contributions are after-tax money. That means you can take out all your contributions and not owe anything to the IRS. If you’ve invested $10,000 in a Roth, you can take out $10,000 anytime you want and not owe taxes or the penalty. It’s only when you take out your investment gains that the tax and penalty apply.
The Traditional IRA is much more restrictive. The tax and penalty apply to every dollar you take out of the Traditional IRA.
Factor #4 – Tax rate in retirement
One other factor to consider is your expected tax rate in retirement. Do you plan on staying in about the same tax rate during retirement or do you think it will drop? In other words, will your retirement income be close to your annual work income?
If you expect to be in the same tax bracket or higher in retirement, the Roth IRA makes more sense. If you expect to be in a lower tax bracket, the Traditional IRA makes more sense. It’s postponing taxes now when you’re in a high tax bracket and pushing that income to retirement when you’ll owe less in taxes on the income. This factor takes more guesswork than the others and should be the least important part of your consideration. If it’s a close call between the two accounts, this could push you towards a final decision.
The IRA you end up using will have a major impact on your overall retirement plan. Take the time to consider all these factors so you end up choosing the best IRA for your needs and maximize your tax savings.
David is a Certified Financial Planner who writes about financial planning, investing and taxes.