Retirement Planning Basics: Traditional & Roth IRAs

IRA Basics: Retirement Planning for Beginners

They say it’s never too early to start planning for retirement, but the retirement resources out there seem to assume that people already have an encyclopedic knowledge of retirement planning jargon. Well, you know what they say about assuming things… so here at NEST, we try to avoid it.

Last time we discussed 401(k)s, and in this segment of our beginner’s guide to retirement planning we’re diving into the IRA, or individual retirement account. An IRA is similar to a 401(k) in that it is a tax-advantaged account whose funds are intended for – you guessed it – retirement.

Like a 401(k), an IRA is composed of stocks, bonds, and other assets, and how much your account accumulates depends on these investment vehicles and how much money you contribute to the account. Either contributions or withdrawals are tax-free, depending on the type of IRA.

However, there are distinct differences between the two types of accounts, and it’s important to understand them so that you can make the best choice for your financial goals and future.

Traditional and Roth IRAs are not associated with your employer, which means they are not eligible for employer matching. They also have much more restrictive contribution limits.

On the other hand, IRAs open up your investment options significantly compared to a 401(k). Rather than being limited by your workplace’s options, IRAs give you more freedom when it comes to how you invest, and also permit more flexibility when it's time to withdraw your funds.

Let’s dive into the details.

The Basics

Instead of being affiliated with your workplace, traditional and Roth IRAs are opened at banks or brokerages. In this context, these financial institutions are called “custodians,” since they take custody of your money.

Since it’s not designed by your employer, an IRA empowers you to design your own portfolio. You get to choose the investment vehicles you want your account to be composed of, from stocks and bonds to mutual funds or ETFs. Another option is to buy a target-date or life-cycle fund, which is a mix of stocks and bonds that are designed to automatically adjust over time as your risk tolerance goes down the closer you get to retirement age.

While IRAs allow for more diversity in investments than 401(k)s, the contribution maximums are much lower. For 2021 and 2022, the maximum annual contribution to all of your IRAs is $6,000 if you’re under 50, or $7,000 if you’re 50 or older.

Because traditional and Roth IRAs aren’t affiliated with your employer, they also don’t come with matching contributions.

Depending on your risk tolerance and goals, it’s a good idea to contribute as much as possible up to the maximum permitted. If you’re not going to need your money in the immediate future, these kinds of accounts offer better long-term growth than letting money sit in a regular savings account.

Also, be aware of different withdrawal rules, contribution limits, and deduction caps based on your income and whether you or your spouse are covered by a retirement plan at work.

Traditional IRAs

Contributions to traditional IRAs are tax-deductible, reducing your taxable income for the year. In retirement, the withdrawals you make from a traditional IRA are taxed as ordinary income.

You must have earned income to open a traditional IRA, and your contributions cannot exceed your annual earned income. However, deduction limits are influenced by income level and access to workplace retirement plans.

For example, in 2021:

• Single individuals can claim the full deduction if their income is up to $66,000.

• Partial deductions are allowed for incomes between $66,000 and $76,000.

• No deduction is available if your income exceeds $76,000.

These thresholds are higher for married couples filing jointly, and they are adjusted annually for inflation.

Roth IRAs

Roth IRAs operate under a different set of rules. Contributions are not tax-deductible, but withdrawals in retirement – including earnings – are tax-free, making them particularly attractive for younger investors or those expecting to be in a higher tax bracket in the future.

In 2021:

• Individuals earning less than $125,000 can contribute the full amount.

• Contributions phase out between $125,000 and $140,000.

• For married couples, the phase-out range is $198,000 to $208,000.

Roth IRAs can be a smart hedge against long-term tax increases and are popular for their flexibility and long-term benefits.

Withdrawals

Like a 401(k), early withdrawals from IRAs before age 59½ may incur a 10% penalty, plus taxes. However, there are exceptions that allow penalty-free withdrawals from a traditional IRA, including:

• First-time home purchase (up to $10,000)

• Certain medical expenses

• Qualified higher education expenses

• Disability-related costs

A major benefit of Roth IRAs is that they do not require minimum distributions during your lifetime, unlike traditional IRAs which are subject to Required Minimum Distributions (RMDs) starting at age 72.

Either / Or / And

IRAs are an excellent way to diversify your retirement planning. They generally offer more flexibility and freedom in how your funds are invested, but come with lower contribution limits than 401(k)s.

You can have both a 401(k) and an IRA. Just keep in mind that your income may affect how much of your IRA contribution is tax-deductible if you also participate in a workplace plan.

Let’s Plan It Out

Creating a retirement strategy that’s right for you depends on your current financial picture, your long-term goals, and how you want to spend your golden years. If that feels like a lot, that’s because it is – and you don’t have to do it alone.

Connect with our team at info@nestfinancial.net to build a personalized retirement roadmap and join other Austin families and individuals taking control of their financial future with confidence.

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DISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net.