Setting aside money for retirement isn’t usually high on the list of priorities for 20-something MBA degree seeking students. Retirement seems so far away it might as well not exist. But time flies and all of a sudden you’re in the latter half of your 30s, retirement is looming, and you find yourself wishing you had started saving earlier.
Planning for retirement means setting a small portion of your income aside now into an interest-bearing account to ensure financial security for yourself and your family in the future. The most popular retirement accounts are 401(k)s, IRAs, and Roth IRAs.
The retirement benefit that employers offer to their employees is called a 401(k) retirement plan. IRS regulations that apply to 401(k)s are very different from those for traditional and Roth IRAs. For example, maximum annual contributions are considerably higher for 401(k) plans.
If your employer does not offer a 401(k), you may choose to open your own individual retirement account (IRA). Traditional and Roth IRAs have distinct differences regarding taxes, income restrictions, and withdrawals. Anyone who plans on starting an IRA should understand the differences between the two.
Traditional IRAs
Individual contributions are limited to $5,500 per year for Traditional IRAs, or $6,500 for people over 50 (2017 numbers). But Traditional IRAs have a few caveats. If you earn less than the maximum contribution amount annually in taxable employment compensation, you can only contribute to your IRA as much as you make in taxable income.
And don’t start hatching plans to sidestep the maximum annual contribution limit.
“If you decide to be a retirement super-saver and open more than one IRA, your contribution limit between all of them is still $5,500 to $6,500,” said Rebecca Reisner, a frequent financial contributor at Learnvest.com, in her 2016 article “Traditional Vs. Roth IRAs: Understanding the Retirement Planning Benefits of Each.”
“In other words,” she said, “you can’t save, say, $11,000, between two IRAs.”
Traditional IRA contributions are made from pre-tax dollars, meaning you will deduct your IRA contributions from your income each year when you file your taxes. So, if you make $50,000 per year, your taxable income will be $44,500 (assuming you contributed the maximum amount of $5,500). Your Traditional IRA will be taxed only when it is withdrawn, either before or after retirement.
If you withdraw money from your Traditional IRA before your turn 59½, you will not only have to pay taxes on the withdrawn money, but also an additional 10 percent tax penalty for early withdrawal.
Finally, Traditional IRAs have a minimum distribution requirement. Once you turn 70½, you must withdraw a certain minimum amount each year to avoid tax penalties.
Traditional IRAs tend to appeal to those in higher tax brackets because of the tax deductions made each year on tax returns. People in lower tax brackets may not care whether IRA contributions are taxed annually because they take advantage of other deductions, such as Earned Income Tax Credit (EITC).
Roth IRAs
Contribution limits for Roth IRAs are the same as for Traditional IRAs. The main difference is that Roth IRA contributions are taxed each year. If you make $50,000, your taxes will be based on the whole amount of income, regardless of how much you contribute to your retirement plan.
If you withdraw money from your Roth IRA at any point (for emergencies, down payments, or even vacations), you can access your contributions without penalty. You only pay a penalty if you touch the interest. For instance, if you contributed $5,500 annually for 10 years, your Roth IRA balance would be around $81,000, including the interest. You can withdraw up to $55,000, or the amount you contributed to the account, without paying a fee.
Roth IRAs also have income restrictions, unlike Traditional IRAs. If you are married (filing jointly), you can’t open a Roth IRA if your modified adjusted gross income is more than $194,000 (2017 numbers).
Finally, Roth IRAs do not have required minimum distributions, even after you turn 70½. The total amount of your Roth IRA could easily, if you choose, be left in the account until you pass away, when it will revert to your spouse or children.
People who fall into lower or middle-income brackets, especially young men and women starting out in their careers, will likely prefer a Roth to a Traditional IRA. The younger you are when you start, the more interest will be compounded before you retire. Also, the prospect of not having to pay taxes on distributions after you retire is an attractive aspect of Roth IRAs.
What Am I Investing In?
Your IRA contributions accumulate interest through a series of investments. You can carefully choose the particular investment mix that works best for you or you can leave the selection up to the strategists at your financial institution or brokerage firm.
“Roth IRAs, on average, include three different types of investments per account,” financial journalist Wendy Connett wrote in her 2014 Investopedia article, “The Most Common Roth IRA Investments.”
“While there are a few exceptions, you can hold just about any investment in this increasingly popular retirement account.”
Spreading capital across multiple investment types is called diversification, and IRAs rely heavily on the concept. IRAs also differ in the amount of “hands-on” participation that investors can contribute. Some allow individuals to pick and choose their investments while others use market strategists and automated systems to manage investors’ money.
The types of investments that make up IRAs include mutual funds, individual stocks, annuities, money market funds, exchange-traded funds (ETFs), and bonds.
Which Roth IRA Should I Choose?
Many financial institutions offer IRA options. Some are more popular than others and some appeal only to specific types of investors, depending on a variety of factors. In her blog post, “Best Roth IRA Accounts: 2017 Top Picks,” for the financial website NerdWallet.com, investment expert Arielle O’Shea lists some considerations people should weigh carefully before choosing an IRA:
• Overall ratings and performance
• Minimum account balance requirements
• Cost/percentage of commissions on trades
• Promotions for opening an account (e.g. free trades, cash bonuses)
• Use of robo-advisers for management
• Designed for hands-off management or hands-on active trading
• Whether the financial institution matches a percentage of contributions
The IRA account you choose depends on a number of factors that will be different for each person. Considerations include participation level, risk level, and promotional offers. You will need to research financial institutions until you find one that offers IRAs designed with your specific needs in mind.
About UAB’s Online MBA Degree Program
The University of Alabama at Birmingham offers an online MBA program with a concentration in finance for students interested in pursuing careers such as corporate finance, investment banking, and accounting. UAB combines traditional university education with the convenience and flexibility afforded by advanced technology.
UAB’s Online MBA program offers four concentrations that reflect growing sectors of the economy – Finance, Health Services, Management Information Systems, and Marketing – as well as a General Track. For more information, visit UAB’s online MBA website.
Sources:
• Traditional vs. Roth IRAs: Understand the Retirement Planning Benefits of Each – https://www.learnvest.com/2016/08/traditional-vs-roth-iras-the-retirement-planning-benefits-of-each/
• The Most Common Roth IRA Investments – https://www.investopedia.com/articles/personal-finance/110614/most-common-roth-ira-investments.asp
• Best IRA Accounts: 2017 Top Picks – https://www.nerdwallet.com/blog/investing/the-best-roth-ira-account-providers/