This post is the 2nd of 3 in the Retirement Plan Series that gives you the basics about retirement plans. Check out part 1 here.
If your employer does not offer a retirement plan or if you would like to contribute more outside of your employer-sponsored retirement plan, then a Traditional or Roth Individual Retirement Account (IRA) may be an option for you.
There are two types Individual Retirement Accounts available to everyone with earned income, a Traditional and a Roth IRA. Since Simple & Sep IRAs are for the self-employed and small businesses I will discuss them in the next post.
Traditional IRA
The Traditional IRA allows your earnings to grow tax-deferred so you don't pay taxes on your earnings until you withdraw money from the account. Unlike the Roth, there is not an income restriction to contribute to a Traditional IRA and the maximum amount you can contribute is $5,500 in 2017 ($6,500 is if you are age 50 and over). You are able to deduct your entire contribution if you don't have an employer-sponsored plan but if you are covered by an employer-sponsored plan then you may only be able to deduct your contributions depending on your income.
Source: IRS.gov
If you withdraw money from a Traditional IRA before you are age 59.5 you may be subject to a 10% penalty, unless you meet an IRS exception (first home purchase, medical expenses, tuition, disability, health insurance, military).
To avoid the penalty, you will have to state your exception when you report the withdrawal from your Traditional IRA on your tax return (make sure you have proof just in case you are audited).
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The Roth IRA
The Roth IRA is considered an after-tax Individual Retirement Account. Since the Roth is an after-tax account you are able to withdraw your contributions anytime, without penalty. You are also able to withdraw the earnings as long as the funds have been held in the account for at least 5 years. Just like the Traditional IRA, you can contribute up to $5,500 in 2017 and $6,500 if you are age 50 and over. To contribute to a Roth IRA (for the 2017 tax year), you must fall within certain income limits, for Single Filers or Head of Household your contribution eligibility begins to phase-out at a modified adjusted gross income of $118,000 ($186,000 for Married Filing Jointly), once your modified adjusted gross income is over $133,00 ($196,000, married filing jointly) you are ineligible to contribute.
Source: IRS.gov
The Roth IRA is favorable over the Traditional IRA if you feel you will be in a higher tax bracket when you retire. Also if you are unable to deduct your contributions to your Traditional IRA due to your income being too high and being covered by an employer-sponsored plan then you may want to consider a Roth IRA (if you meet the income limits).
In both the Traditional and Roth IRA, you are NOT restricted to investing in mutual funds/stocks picked by your employer. Typically, you will have the option of investing in all of the funds available through the investment company (custodian) you choose. But keep in mind, you will still have to meet their investment requirements, so for example, if you are opening a Roth IRA and you have $1,000 to invest, if the minimum investment in the mutual fund you choose is $1,000, you can only invest your money in one mutual fund in the Roth IRA. Once your balance increases to $2,000 (due to additional contributions or market performance) then you may be able to transfer $1,000 into another mutual fund and now you will have 2 mutual funds in your Roth IRA account. There are some investment companies that allow for you to start investing at a lower rate by signing up for an automatic investment plan.
Sometimes people ask which IRA is best. I personally don't think one is better than the other, it all depends on your personal financial situation. A lot of people push the Roth because the contributions are after-tax and you have the opportunity to withdraw the funds later without penalty, but depending on your situation (taxes and income) it may be best for you to contribute to a Traditional IRA and then you can bring a Roth IRA mix later. It's best to compare the two accounts and pick the option that is best for your situation.
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