If you’re like us, retirement seems like an impossible milestone that only some people are lucky enough to reach (like your boss’ boss). Sadly, the reality for most Americans is that they won’t be able to retire without their children’s financial support. UNLESS they make a change. You’ve probably seen a TV commercial or heard someone at work talk about saving for retirement. Well, an IRA is one of the ways that you can save for retirement! Most people have heard of a 401K but may not know what an IRA is. So what is an IRA? What is a Roth IRA? Read more to learn the difference!
Let’s be honest here. When we first started our careers, we had absolutely NO idea what a Traditional IRA or a Roth IRA was. Not even the slightest clue, other than it was a ‘retirement thing’. Francisco spent the majority of his 20’s in school. Camilo, however, started working in NYC when we has 22 years old. Unfortunately, with no one to teach him about personal finance, he didn’t realize he should have opened a Roth IRA for several years. Camilo finally opened his Roth IRA at age 25, which is still awesome. But it would’ve been a big help to have opened it earlier.
The reason, is that when investing over a long time horizon, like for retirement, the amount of time you invest is INCREDIBLY important. Maybe even more important than the amount of money that you invest. Now that we spent the time to learn the ins and outs of IRAs, we both contribute to them regularly and have never looked back.
Today, we will teach you everything we wish we would have known years ago.
What is an IRA?
An IRA (Individual Retirement Arrangement) is a retirement account that offers tax benefits. The basic idea is that you place your own money into an IRA account and use the money later in life during retirement. Once invested, the money you place in the account will earn interest, dividends, and capital gains (investments will grow in value).
There are different types of IRAs available. In general, these include Roth IRAs, Traditional IRAs, SIMPLE IRAs, and SEP (Simplified Employee Pension) IRAs. Let’s begin by taking a look at the original IRA (aka Traditional IRA). Then let’s move to the Roth IRA, our personal favorite. These two IRAs are the two you should become familiar with first.
Anyone can open a Traditional IRA as long as you earned taxable income during the year and are less than 70 and ½ years old. They are usually opened at a bank or other financial institution (including online). We think online is the easiest route.
Contributions, interest, dividends, and capital gains in Traditional IRAs are not taxed IN the year earned, but are taxed when the money is withdrawn from the account. Once the money is withdrawn, it is taxed as ordinary income. Withdrawals from a Traditional IRA can be done at any time. However, a 10% additional tax will apply if you withdraw your money prior to turning 59 and ½ years old (unless you qualify for exceptions).
One of the unique features of the Traditional IRA is that you can deduct contributions from your income for tax purposes, based on filing status, income, and other available retirement accounts. This means that you will defer taxes now until you retire! You can deduct 100% of your Traditional IRA contributions when you file taxes as long as you are not covered by an employer-sponsored retirement plan at work (pro tip: look at your W-2 for the year and make sure the “Retirement plan” box is not checked).
If the “Retirement plan” box is check on your W-2 is checked, then your deduction depends on your filing status and income. If you file as single or head of household and your modified adjusted gross income (AGI) was $63,000 or less (2018) for the year you can still deduct 100% of your contribution. However, If you earn more than that, you are eligible for a partial deduction ($73,000 or less) or no deduction (more than $73,000).
Contribution Limits are $5,500/year (or up to $6,500/year once you turn 50 years old). If you earn less than $5,500 during the year, you can only contribute up to the amount you earned. For example, if you earned $2,600 during the year, you can only contribute $2,600 for that year.
Although you can open more than one IRA, you cannot exceed the maximum contributions to all accounts when you add up all contributions. For example, if you have three Traditional IRAs and one Roth IRA, and have earned more than $5,500 during the year, your max contribution between all four IRAs cannot exceed $5,500. If you exceed the contribution limits for a given year, you must report it and pay a 6% tax for excess contributions.
What is a Roth IRA?
Roth IRAs are similar to Traditional IRAs, but there are some important differences.
Unlike Traditional IRAs, Roth IRAs can be withdrawn tax free after age 59 ½. Additionally, you can withdraw your contributions (ONLY the total you contributed, NOT any of the investment gains) at any time, tax and penalty free! If you take an early distribution of the investment gains, you will be subject to the 10% penalty. There are also exceptions to withdrawing money prior to turning 59 ½, so be sure to make sure you qualify before you withdraw any money.
Sounds pretty great, right? You’re probably wondering what the catch is. One is that you cannot deduct contributions made to a Roth IRA on your taxes. If you’re single and your total itemized deductions are not more than the standard deduction ($12,000 in 2018) this may not be a big deal.
The 2nd catch is that there is an income limit to contribute to a Roth IRA. You can contribute towards a Roth IRA as long as your income is NOT above a certain threshold based on filing status. For those filing as single or head of household you can make a full contribution ($5,500 or $6,500 if 50+ years old) if your modified AGI (adjusted gross income) is less than $120,000 (2018). You can make a partial contribution up until your modified AGI hits $135,000 at which point you are no longer eligible to contribute to a Roth IRA. For most of us, this income limit isn’t that relevant, but important to be aware of!
What is a SIMPLE IRA?
SIMPLE IRAs (Savings Incentive Match Plan for Employees of Small Employers) are used by small employers and companies. If the small business you work for uses SIMPLE IRAs you can still contribute to your own Traditional IRA or Roth IRA.
What is a SEP IRA?
SEP IRAs (Simplified Employee Pension) allow employers to contribute money to their employees retirement via a Traditional IRA! Employer SEP IRA contributions do not count towards your own Traditional or Roth IRA yearly contribution limit. Few companies do this, but it’s good to be aware of.
Traditional IRAs vs Roth IRAs
Which type of IRA should you get?
Long answer: It depends. If you expect to earn a higher income in the future you may jump into a higher tax bracket. In that case, putting your money into a Roth IRA now might make more sense. Since you are currently in a lower tax bracket why not pay the taxes now (at the lower rate) so you can use take the money out tax free once you are in the higher tax bracket (and avoid paying that higher tax). On the other hand, if you are in your top earning years, you can put the money into a Traditional IRA since you will likely be in a lower tax bracket during retirement.
Short answer: Since we are still in our 20’s and our best earning years are ahead of us (like many of you!) we use Roth IRAs.
How do I open an IRA?
You will need to set up your IRA in a brokerage account. Many large banks can help you set up a brokerage account, but we recommend going with a discount online brokerage for one main reason: less fees.
When you’re first getting started, you simply do not have that much money. By minimizing the amount of money you pay the brokerage firm (in fees), the more you are investing in the account. There are many such companies out there, which we will cover below.
Remember, by managing your own account (with low fees), you get to keep more of what your investment earns. If the market goes up by 8%, you should get as much of that as possible. You not only deserve it, you have EARNED it! If you pay someone 2%, you will only get 6% (and that is assuming they earn as much as a diversified index fund, which may not even always be the case).
Where do I open an IRA?
There are many options including Charles Schwab, E-Trade, Fidelity, and Scottrade. However, Vanguard is our favorite because of their low cost index funds. In case you are wondering, this post wasn’t sponsored by anyone, and we are not making money by recommending Vanguard. We just think they have a great product!
The minimum amount needed to open a Roth IRA with Vanguard is $1,000 dollars, but many of their funds have a $3,000 requirement. One of the popular funds they offer that you can choose to invest in is the “Vanguard Target Retirement Funds” ($1,000 minimum).
We love these funds, because they are diversified portfolios that change over time based on your target retirement year, making it easy to manage because they handle all of your asset allocation for you! The further you are from your retirement the more risk you should take to maximize your retirement account.
Is it hard to manage an IRA?
No! One easy way to diversify your portfolio is by owning the entire stock market. It may sound impossible, but by putting your investments in index funds (like an S&P 500 index fund), you are guaranteed to get the same return of the entire stock market. Historically, this has been a winning strategy. The market may go up and down, but over extended periods of time, it has always gone up! Data has shown that picking stocks is for dummies. If you don’t believe us, just google what Warren Buffet has to say about index funds. We will just save you the trouble though, because he freaking loves them.
If you’re ready to get started, head over to Vanguard: www.vanguard.com. Reminder: Vanguard did NOT elicit this recommendation and we do not profit if you choose to invest with Vanguard. Not a single buck. We just want you to help yourself!
Remember, taking control of your financial future starts one buck at a time!
Comment below to tell us where you keep your IRA or if you have any questions! So what is a Roth ira? Now you know the answer!