Compare the maximum annual contributions allowed for IRAs and 401(k)s, and you could reasonably assume that IRAs aren't very powerful. You'd be wrong, though. They can help you build a surprisingly large war chest for retirement, in a tax-advantaged fashion.
Better still, the tax advantage for Roth IRAs is that if you play by the rules, your withdrawals in retirement -- a time when every dollar can be especially valuable -- will be tax free. Here's a look at what a Roth IRA might do for you.
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An introduction to IRAs
Let's first review just what IRAs are and how they work. There are two main kinds of IRAs -- the traditional IRA and the Roth IRA. With a traditional IRA, you contribute pre-tax money, reducing your taxable income for the year, and thereby reducing your taxes, too. Taxable income of $70,000 and a $5,000 contribution? You'll only report $65,000 in taxable income for the year. If you're in the 24% tax bracket, you can avoid paying $1,200 in tax on that $5,000 in the contribution year. The money grows in your account and is taxed at your ordinary income tax rate later -- when you withdraw it in retirement. Many of us will be in lower tax brackets in retirement, so not only is our taxation postponed, but it's often reduced. That's the tax break you get with a traditional IRA.
A Roth IRA, meanwhile, receives post-tax contributions, so your taxable income isn't reduced at all in the contribution year. Taxable income of $70,000 and a $5,000 contribution? Your taxable income remains $70,000 for the year. The great thing about the Roth IRA, though, is that if you follow the rules, your money grows in the account until you withdraw it in retirement -- tax-free.
Another difference between the two kinds of IRAs is that traditional IRAs feature required minimum distributions (RMDs) that you must start taking once you turn 70 1/2. Fail to take them on time and in the correct amount, and you can face stiff penalties. Roth IRAs, though, don't feature RMDs. (But note -- if you inherit any kind of IRA, Roth or traditional, you'll likely face RMDs.)
These RMDs can be more than just a headache, forcing you to take money out of your IRA when you may not want or need to. They will increase your reported income for the year, and they may kick you into the next tax bracket. If you move that RMD money into your regular taxable brokerage account, then as it grows and generates gains, those will be taxable, too. Thus, the fact that the Roth doesn't compel you to take RMDs is another tax plus. You get to choose how long to leave your assets in the account and when to withdraw them -- or even to not withdraw them and instead pass them on to heirs.
Turbocharge your financial security in retirement
So how much can you sock away in an IRA? Well, IRA contribution limits for the tax year 2017 are $5,500, plus an extra $1,000 "catch-up" contribution for those age 50 or older, letting those folks sock away as much as $6,500 for the year. (Note that you can make contributions to IRAs for the 2017 tax year until the April tax-filing deadline in 2018.) For the 2018 tax year, the limits are the same. (I mentioned 401(k) contribution limits in the introduction. Just for comparison's sake, know that they're $18,000 and $18,500, respectively, for 2017 and 2018, with an additional $6,000 allowed in both years for those 50 and older.)
For best results when saving for retirement with an IRA, contribute as much as you can -- and as soon as you can. The longer your money has to grow, the more it can grow. Even contributing at the beginning of each year instead of at the last minute can make a difference.
To appreciate how valuable it is to max out your annual contributions, imagine that you contribute $4,500 every year for 25 years to an IRA and it grows at 10% annually. That will amount to nearly $487,000 -- which is pretty good. But if you contribute $5,500 annually (just $1,000 more) and it all grows at 10% per year, the end result will be $595,000 -- a difference of $108,000! Of course, as the annual contribution limits rise each year, you should aim to keep contributing more (and once you hit age 50 you can make the extra "catch-up" contributions, too), ending up with an even bigger nest egg. The table below shows how you can accumulate some very significant sums with annual $5,500 contributions:
Here's where you can really see the power of the Roth IRA: If you accumulated the amounts above in a traditional IRA, they would be taxable income to you upon withdrawal -- but would be all yours with no taxes due if they were in a Roth. Yes, your original contributions were made with taxed dollars -- but all that growth is tax-free. Imagine that you accumulated $600,000 in your IRA account. If you withdrew it over your retirement and were taxed an average of 12% on it, you'd fork over $72,000, a rather meaningful sum. If your tax rate on it was more like 24%, you'd be paying a hefty $144,000. You can keep that all in your pocket with a Roth IRA.
How to invest through your Roth IRA
So what, exactly, should you invest in, in your Roth IRA? Well, one difference between IRAs and 401(k)s is that IRAs let you invest in individual stocks and a huge range of mutual funds, whereas 401(k)s tend to offer a very limited menu of mutual funds. Mutual funds are a good solution for most people, as they offer instant diversification across lots of investments. Among them, consider favoring index funds (which are passively managed), because index funds tend to outperform actively managed funds. Indeed, according to the folks at Standard & Poor's, as of the end of June 2017, fully 85% of all domestic stock mutual funds underperformed the S&P 1500 Composite Index over the past 10 years, and 85% of large-cap stock funds underperformed the S&P 500.
For a good low-cost broad-market index funds, check out the SPDR S&P 500 ETF (SPY), which distributes your assets across 80% of the U.S. stock market. The Vanguard Total Stock Market ETF (VTI)or the Vanguard Total World Stock ETF (VT) are also sound choices, respectively investing you in the entire U.S. market, or just about all of the world's stock market.
Annual contributions of $5,500 or $6,500 can seem like peanuts that won't amount to much, but that's just wrong. An IRA, especially a Roth IRA, can be a powerful way to make your retirement more secure and comfortable.
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