Individual Retirement Account (IRA) FAQs

When it comes to retirement, having a proper savings account is essential. There are many options out there, but I want to specifically discuss IRAs, which stand for individual retirement accounts. Two of the most common IRAs are Roth and traditional. Both traditional and Roth IRAs provide tax-deferred growth, and both have special rules regarding money going in and out of the account.

In a traditional IRA, you contribute a portion of your pre-tax income, which reduces your taxable income for the year. Once you reach retirement age, you will pay taxes due at that time. This can be beneficial if you're in a high tax bracket now and expect to be in a lower bracket in retirement.

In a Roth IRA, you contribute a portion of your after-tax income, and you do not receive any deductions. In retirement, you will not pay taxes on the funds you withdraw from this account, since you've essentially paid them up front. This is beneficial for anyone who is in a lower bracket now and would anticipate being in a higher bracket later.

Roth IRAs provide tax-deferred growth and tax-free withdrawals in retirement. They remove a crucial variable from the future: “what will my tax rate be?” With a Roth, you're locking in the rate at which you paid taxes. Personally, I think taxes will go up over time, so if it makes sense for your tax picture to lock in your tax rate now, a Roth IRA might be a good fit. They also serve as a way to earmark a specific portion of your net worth to serve as future income in retirement.

The IRS sets specific requirements to open an IRA, and not everyone will be eligible. If you make too much money (or if you do not make money from eligible sources) the IRS says you cannot participate in this tax-advantaged savings account. It's best to determine if you're eligible by talking with a tax advisor or going directly to the IRS website. If you're eligible and under 50, you can contribute up to $7,000 in 2024. If you are 50 or older, you can contribute the $7k PLUS an additional $1k (8k total).

You don't receive any deductions to your income for contributing to a Roth, however, the funds you eventually withdraw will be tax-free. You gave the IRS what they wanted up front (in the form of taxes) so you don't owe them anything later on, like you would in a traditional IRA.

While my best practice is to treat your IRA as a permanent savings account, life can throw curveballs that may result in an unexpected withdrawal from your IRA. Within a Roth IRA specifically, any contributions made to the account can be withdrawn tax-free and penalty-free. However, if you withdraw earnings, you will be subject to a 10% early withdrawal penalty, and it will count toward your taxable income for the year.

One exception for Roth withdrawals is when you're putting it toward a first-time home purchase. Up to $10,000 in Roth IRA earnings can be withdrawn — free of both taxes and penalty — for a home purchase if you meet certain requirements. That's in addition to being allowed to withdraw your direct contributions at any time.

If you've made eligible contributions to your Roth, it can remain in the tax-deferred account for your lifetime. You will not be required to withdraw money like you would in a traditional IRA. If you pass your Roth IRA to a beneficiary they'll also benefit from the tax-deferred, tax-free income.

While having money in a Roth is great, the contributions need to be invested to work harder for you over time. The more you can accumulate in dividends, interest, and capital gains, the more beneficial it will be. It's best to ask a financial professional for guidance or advice if you're unsure.

Understanding Individual Retirement Accounts (IRAs), particularly Roth and traditional IRAs, is essential for retirement planning. As discussed with Maggie Dolan, CFP®, these accounts offer distinct advantages, depending on your current financial situation and future expectations regarding tax rates.

Whether you opt for the immediate tax benefits of a traditional IRA or the long-term tax-free withdrawals of a Roth IRA, each can play a crucial role in securing your financial future.

As you navigate your retirement savings journey, consider consulting a financial advisor to tailor your approach to your unique circumstances and ensure that you're making the most of these valuable savings tools. With informed decisions and strategic planning, you can work toward a more stable and fulfilling retirement.