While 401(k)s are powerful retirement savings vehicles, if you started saving late for retirement, they may not be enough to fund the retirement you envision.
Fill your retirement funding gap by also investing in a traditional or Roth IRA. Both offer tax breaks to aid you in building your wealth.
IRAs are great retirement savings vehicles because they compound on a tax free or tax-deferred basis. Unlike a 401(k) or other employee-benefit plan, in which you usually have a set amount of choices, your IRA investment options are virtually limitless.
You also can put the power of compound interest to work for you to build your retirement nest egg. By investing just $4,000 per year that money can grow to a hefty amount over time.
- If you contribute $4,000 annually to an IRA for the next 20 years and the money earns 7%, you'd have $175,000 at the end of that time.
How do you decide which IRA is best for you? There are significant differences between a traditional IRA and a Roth IRA. The one you choose will depend largely on your age, current income, and distribution goals.
While both IRAs can help build wealth for retirement, when and how you receive a tax break from each IRA is different.
With a traditional IRA, if you qualify, you could take a deduction on your federal income taxes. Your ability to claim a full tax deduction depends on your income, marital status, and whether you or your spouse participates in an employer-sponsored retirement plan. But even if you can't claim a tax deduction, you still benefit from tax-deferred growth and compounding.
Earnings on your contributions are tax-deferred so you won't have to pay taxes on IRA investment earnings until you begin taking distributions from it. All of the money you put into this IRA will benefit from tax-deferred compounding. When you do start paying taxes on the principal and earnings in retirement, you may realize additional savings if your tax bracket is lower than what it was during your peak earning years.
Generally, for distributions from a traditional IRA before 59½, you must pay a 10% penalty on the amount you withdraw. This is in additional to ordinary income taxes. You must start taking distributions from a traditional IRA shortly after you reach age 70½.
With a Roth IRA, you pay taxes now and get a break later. But if you keep the money in the account for at least five tax years and take no distributions until you're 59½, in most cases, you won't have to pay another cent - even on the earnings.
With Roth IRAs, you can withdraw contributions without penalty at any time because you've already paid taxes on them. If you are in a higher tax bracket during retirement than you were at the time you contributed to the Roth IRA, your tax savings can be substantial.
A couple other big advantages of a Roth IRA over a traditional IRA is that as the owner of the Roth IRA you won't be forced to take distributions at any age. However, your beneficiaries will have to start taking distributions after your death. This allows your assets to grow tax-free for as long as you want.
Choose wisely when sorting out which is the best IRA to help you to reach your retirement goals.
This material is for informational purposes and is not intended as tax or legal advice. You should consult with your tax advisor or legal counsel for advice and information concerning your particular tax situation.
No investment strategy can guarantee a profit or protect against a loss.