For as straightforward a concept as retirement can be, establishing a solid financial footing for your retirement years can be anything but straightforward. Between 401(k)s, IRAs, Roth IRAs, and various other types of retirement accounts, the alphabet soup of it all can feel intimidating and overwhelming to someone who isn’t well-versed in the mechanics of modern investing.
Thankfully, what might seem complicated from a distance can actually be quite simple with just a novice understanding of the different types of retirement accounts and what each is designed to accomplish.
Since most people are familiar with the basics of employer-sponsored retirement plans like 401(k)s, IRAs are often the most misunderstood of the retirement accounts. However, a brief explanation of the different types of IRAs can go a long way in helping you overcome the confusion and help you to choose an account that is best suited for your particular needs.
From a tax perspective, a Traditional IRA will work much like a 401(k) at work. Instead of your contributions coming straight out of your paycheck, you must manually contribute money into the account. You will receive the tax deduction once you file your taxes that year.
Since contributions to a Traditional IRA are made on a pretax basis, they provide the most tax benefit to those in a higher tax bracket now rather than later when the distributions are taxed.
The only substantive difference between a Roth IRA and Traditional IRA is when each is taxed. Unlike a Traditional IRA, contributions to a Roth IRA provide no immediate tax benefit to you upfront. In other words, whether you contribute nothing to a Roth IRA or make a maximum contribution in any given year, your taxable income remains the same.
For that reason, a Roth IRA truly shines for those in lower tax brackets now than they expect to be upon taking distributions in retirement. Although you might be sacrificing the pretax benefits of a Traditional IRA, a Roth IRA allows you to generate tax-free growth that would otherwise be impossible to accomplish with any other IRA.
A first cousin to a Traditional IRA, a Rollover IRA is a convenient way to remove an employer-sponsored retirement account like a 401(k) when you choose to switch jobs without triggering any taxes or penalties. Given the ever-growing turnover rates in the workforce these days, most people will change jobs at some point and feel uncomfortable leaving their 401(k) with that former employer.
Using a Rollover IRA, you maintain control of your retirement assets even when you switch jobs. Under certain circumstances, you can roll an old 401(k) directly into your new one, but at least from a convenience perspective, a Rollover IRA is a more popular choice.
Like most factors involved in your personal finances, you have several different choices to help you save for your retirement. Although there are a few other types of IRAs other than those mentioned above – like SIMPLE IRAs for the self-employed and small businesses – the three discussed are by far the most common. When choosing which IRA is best for you, be certain you understand the pros and cons of each and use the one that best suits your specific needs.
Is a Traditional or Roth IRA better for your situation? How does it affect the taxation of your financial plan? We’re here to help! Simply click here or call (763) 445-2772 to schedule a complimentary consultation today!