People save for a number of reasons, including for retirement. While it is plenty important to devote a certain amount of your financial resources toward saving for retirement, we need to figure out how much we can comfortably contribute to this and seek a balance between our present spending and saving for various points in the future, including for retirement.
People often do not plan enough for their retirement, and they don’t plan their savings that well overall either, and it’s important to plan for all of these things properly. We should be thinking rather carefully about how we spend our money and how much we save for various things, because this all has important consequences for our financial health and well-being.
Instead, many of us tend to conduct our financial affairs too capriciously, although some people are more responsible than others. This all starts with examining our present resources and deciding how much to allot to present needs and wishes, and how much to set aside for other things, including and perhaps especially for retirement.
Once we have figured out the appropriate amount that we will contribute to retirement, based upon a comparison of value and needs, we are then prepared to decide how we are going to save or invest this money.
IRA Income Limitations
The first thing we need to look at when we’re considering contributing to an IRA, once we’ve decided that we can make contributions to one, is what we qualify for and what benefits can be derived from this qualification.
If you do not have a work sponsored retirement plan, if you are single, or neither you or your spouse are covered by employer sponsored retirement accounts, then you need not worry about income limits in order to get the tax deduction benefits from a traditional IRA, but many people do have a retirement plan at work.
If you do, then your income needs to be modest enough to be able to take advantage of these tax deductions, which are at the heart of the reasons to have this type of IRA. An individual who makes over $73,000 won’t be able to make any deductions, which is also the case if a couple makes over $121,000 together. A lot of people’s income fall beneath these limits but many exceed it, in which case they will need to look for alternatives.
The threshold is higher for Roth IRAs though, where maximum income is 135,000 for individuals and $199,000 for couples, so those who fall outside the maximum limits of a traditional IRA may want to consider a Roth IRA if their income is within its tolerance levels.
People can still contribute to a traditional IRA over these limits, and the earnings within the plan will be tax sheltered, but this just means they will wait to pay tax on them later when withdrawn, at a tax rate that will depend on their income at the time.
With a Roth IRA, income earned is tax free, and tax free is certainly preferable to potential reductions in tax. If your income is beyond the limits of the Roth IRA though, just getting the potential tax benefits on earning will be your only option to realize tax savings, although in this case it’s important to ensure that you actually will be in a lower tax bracket when you take the money out.
People who are not covered at work can contribute to a traditional IRA regardless of income, but only up to the maximum contribution limits, which lose significance as one’s income goes up. High income earners who have no other tax advantaged retirement account will usually want to contribute more to their retirement than this and will need to do so in unregistered accounts, although that’s perfectly fine if there is no way to get this extra money tax sheltered in some respect.
The idea here behind IRAs is to help people who do have a more modest income and not do so as much for high income taxpayers, and the fact that high earners pay a higher rate of tax than people of lower income also reflects this.
If we are able to take advantage of the contribution amounts allowed by IRAs, and we are indeed looking to set aside money for retirement, it is generally wise to put it in an IRA of some type, either a traditional or Roth IRA, because of the tax benefits involved.
The Commitment Involved with IRAs
It is generally required that we keep all of the money we put into a traditional IRA until at least age 59 ½, and this isn’t really unreasonable given that this is supposed to be for retirement, and most people retire after the age of 60. People are actually retiring at a later age than they used to generally, even though there are still some that do have the opportunity to retire earlier than 59 ½.
If you are expecting to retire early, you do need to take this rule into account, and it may be that you decide that the tax benefits involved are just not worth the 10% penalty that is involved. If an account is held for many years though, or is at least expected to be, then the tax advantages of an IRA can exceed this penalty and even by a good amount if you have realized a good or especially very good rate of return over this time.
People aren’t really generally that certain of what sort of average return they may expect over a long period of time, so there is some guessing here, but as a rule if the money will still be in an IRA for many years than a traditional IRA might be worth considering, in spite of the penalty.
Roth IRAs are more flexible in this regard and actually are the clear choice for people who expect to retire before 59 ½. Amounts that you have contributed to it can be withdrawn without a penalty at any time, and at any age, and even offer a way that earnings can be withdrawn without a penalty before 59 ½ by setting up a schedule of annual withdrawals.
Whenever we decide how much we can save for retirement, and especially how much we will need to set aside for other contingencies, we are operating with incomplete knowledge, and events may arise that may cause us to want or even need to tap into these savings.
The age commitments that IRAs require can certainly be to our benefit, especially if we are prone to wanting to bail on the plan somewhat and spend our retirement money when we don’t really have to, but there may be times when we actually do.
Deciding on the Suitability of Traditional vs. Roth IRAs
For those that this may be a concern with, or even those who just want to keep their options open more and look to avoid these penalties in times of need, Roth IRAs can be the clear better choice.
With traditional IRAs, you do need to at least look at what potential tax savings there may be when you withdraw, where the goal is to not just use the tax money that you have deferred with your contributions, which is a worthwhile goal in itself, it is also to expect to pay less tax on it.
A lot of people, including so called experts, tend to focus too much on the benefits of cashing out at a lower tax rate and not focus enough on the other benefits, and the other benefits can actually be pretty significant indeed.
We essentially get to borrow the government’s money interest free and earn income from it, as well as paying it back in future dollars, and future dollars are always worth considerably less than present dollars due to inflation.
This is in itself a sweet deal even if your tax rate does not decrease, although most often people do see a reduction in income when they retire, which may be significant enough to reduce their marginal tax rate.
We may even see this as a bonus, although as it turns out, this bonus is pretty much necessary to make a traditional IRA preferable over a Roth IRA. Just because we enjoy benefits from a traditional IRA over doing nothing doesn’t mean that we should contribute to one, if we will enjoy even more benefits from a Roth IRA.
We therefore tend to look at reductions in tax a lot when recommending which one to choose, and while that makes sense to do, our expected rates of return play a big factor as well. If you are investing in things that have a higher potential for growth, this will favor the Roth IRA because you can save more in tax overall by having these larger returns completely shielded from taxation.
This can outweigh the tax benefits of paying a lower rate on the entire amount that a traditional IRA offers, which is why expecting to take advantage of this reduction is considered to be a prime reason and even an essential one in deciding to go with a traditional IRA over a Roth IRA.
As mentioned, the greater flexibility of the Roth IRA may matter, especially with those who have any real uncertainty about whether or not they will need to tap into this money before age 59 ½ and avoid paying a penalty to do so. A 10% penalty is pretty steep, although if it is very unlikely that we will need to do this, we wouldn’t want this to influence our decision here very much.
Deciding between a traditional and Roth IRA isn’t an either/or choice, as we can have both, and many people do. This allows us to hedge our bets more so to speak, and as our retirement plans progress, we can change the allotments to reflect any changing circumstances and needs.
We may, for instance, want to contribute a certain amount of principal into a Roth IRA which can be accessed any time if we need it, enough to take care of any concerns about this, and put the rest into a traditional IRA. As things change, we can even roll over amounts in a traditional IRA into a Roth one if it is advantageous to do so.
IRAs are valuable tools to help us achieve our retirement goals, and provided that we qualify to contribute to an IRA, one or both types, it very often will make sense to take full advantage of them and enjoy the tax breaks that the government is offering us to help us get to where we need and want to be when we retire.