You know you need to be socking away as much for retirement as you can. But are you putting it in the right type of account to maximize your investments? In part one of this episode you'll learn the differences between traditional and Roth IRAs and who can have one.
Money Girl
173 MG Advice About Traditional and Roth IRAs, Part I
You know you need to be socking away as much for retirement as you can. But are you putting it in the right type of account to maximize your investments? In part one of this episode you'll learn the differences between traditional and Roth IRAs and who can have one.
- Broadcast on:
- 12 May 2010
- Audio Format:
- other
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I'm a big fan of the IRA or individual retirement arrangement when it comes to saving for retirement. But I've found that many people are unclear about IRAs. They aren't sure who can have one or how an IRA really works. If you're a more experienced investor, you may know the answer to those questions, but still be uncertain about whether a traditional or a Roth IRA is right for you. I'll help you with the answers to those questions in this and the next show. OK, let's start with the basics. A fundamental concept to understand about an IRA or any retirement account for that matter is that it's not an investment. An IRA is an account for your investments. Think of it like your house or apartment. It's a shelter that protects you, but it's not you. In a similar way, an IRA is also a shelter that protects your investments while they're owned inside the account. You can put just about any investment in an IRA, such as stocks, bonds, exchange-traded funds, mutual funds, and CDs. There are even special kinds of accounts called self-directed IRAs that allow you to invest directly in less mainstream investments, like real estate and businesses. But I'm just going to focus on traditional and Roth IRAs here. A traditional IRA is available to anyone who's younger than age 70 and 1/2 and has earned income. Earned income could come from your job, business, taxable alimony receipts, or even from your spouse if you're married and don't work. For 2010, you can contribute an amount equal to your earned income up to $5,000. However, if you're age 50 or older, you can make an additional catch-up contribution of 1,000 for a total of 6,000. If you or a spouse don't have a retirement plan at work, like a 401(k) or a 403(b), you can deduct all of your IRA contributions from your income. That means you don't pay tax on the amount you contribute until you withdraw money from the account during retirement. Here's an example. Let's say you're 30 years old, earn $35,000 and file taxes as a single person. If you max out your traditional IRA by contributing $5,000 in 2010, then you only have to pay tax on $30,000, not on $35,000. The $55,000 IRA contribution gives you a tax savings of just about $850. So every dollar that you contribute to a traditional IRA lowers the amount of money that you're taxed on in the current year. If you do have a retirement plan at work, you can still max out a traditional IRA, but some or all of your contributions may not be tax deductible depending on your income. Another great benefit of a traditional IRA, whether you have a retirement plan at work or not, is that when your investments grow in value, you're not taxed on your growth each year. When you have a regular non-retirement brokerage account, you do have to pay tax each year on income from certain types of investments like CD dividends and bond interest. So with a traditional IRA, you defer paying taxes on both your contributions and earnings until you withdraw money in the future. Distributions from a traditional IRA can be made once you reach the official retirement age of 59 and 1/2, and they have to be made once you turn 70 and 1/2. ♪ He's better over here ♪ AT&T customers switching to T-Mobile has never been easier. We'll pay off your existing phone and give you a new one free, all on America's largest 5G network. Visit tmobile.com/carrierfreedom to switch today. (upbeat music) Pay off up to $650, the virtual prepaid master card in 15 days, free phone up to $830, be a 24-monthly bill credits plus tax, qualifying court and trade and service on Go 5G next to credit required. Contact us before canceling entire account to continue bill credits to credit stop and balance and required finance agreement as do. - Earning your degree online doesn't mean you have to go about it alone. 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Again, visit morganstandley.com/invested@work to listen today. - If you get antsy and decide to take money out of a traditional IRA before you're 59 and a half, in most cases you'll be hit with a 10% early withdrawal penalty plus ordinary income tax on the amount. Now let's switch gears and cover the Roth IRA. Unlike the traditional, the Roth is only available to those who make under a certain amount of money. I'll go over the income restrictions in just a moment. How much you can contribute to a Roth IRA is the exact same as with a traditional IRA. As I mentioned, it's an amount equal to your earned income up to $5,000 or up to 6,000 if you're age 50 or older for 2010. With a Roth IRA, there's no age deadline for making contributions. You can put money in it for the rest of your life. Remember that for a traditional IRA, you can't make contributions after you reach age 70 and a half. The taxation of contributions to a Roth works just the opposite from a traditional IRA. Contributions are not deducted from your gross income. Another way of saying that is that Roth contributions are not tax deductible. Let's go back to my earlier example. You're 30 years old, earned $35,000 and contribute $5,000 to a Roth IRA. In this case, you'd have to pay tax on your full earnings of $35,000. But the really great thing about a Roth IRA is this. That's where your taxation ends. When you retire and begin to take money out, you won't owe a penny in taxes. You don't even have to pay taxes on the growth in the account that accumulated over many years. With a Roth IRA, your investments are allowed to grow completely tax-free, which is a really big deal. Additionally, there's no requirement to take minimum distributions at age 70 and a half as there is with a traditional IRA. Money can sit there forever, which makes the Roth a nice way to pass money onto your heirs. However, if you take money out of a Roth IRA before you're 59 and a half, you have to pay a 10% early withdrawal penalty on just your earnings. Having a retirement plan at work has no bearing on a Roth IRA. However, as I mentioned, you can't contribute to a Roth if you make too much money. The upper income limit for your modified adjusted gross income is 120,000 or 177,000 if you're married in file a joint tax return. It's easy to open up a traditional or Roth IRA at an online brokerage like Share Builder, E-Trade, or Scott Trade. There's also another way you can start a Roth IRA. Convert all or a portion of a traditional IRA into a Roth account. I covered Roth conversions in a previous show, so be sure to listen to episode 154 for details about the new 2010 conversion rules. Now that we've covered the basics of traditional and Roth IRAs, in part two of this topic, we'll get a little more advanced. I'll give you tips for figuring out which type is right for you and tell you the best types of investments for each one. A couple more things before I go. There's a brand new podcast on the network that I know you'll wanna check out. It's the Get Fit Guys quick and dirty tips to slim down and shape up, hosted by Ben Greenfield. Ben was voted professional trainer of the year in 2008 and he sure knows his stuff when it comes to sports science and exercise physiology. If you're on Twitter or Facebook, be sure to connect with me. My Twitter handle is the same as my name, Laura Adams. And you can find me on Facebook by doing a search for Money Girl. I'll see you there and I'm glad you're listening. Cha-ching. That's all for now. It's the courtesy of Money Girl, your guide to our richer line. (upbeat music) Imagine earning a degree that prepares you with real skills for the real world. Capella University's programs teach skills relevant to your career so you can apply what you learn right away. Learn how Capella can make a difference in your life at Capella.edu. Curious how equity compensation can help build employee financial confidence and move your business forward? Tune in to the latest episode of Morgan Stanley at Work's Invested at Work podcast where we explore the power of financial benefits and how they can help your employees in the workplace and beyond. Listen now by visiting morganstandley.com/investedatwork or stream on Apple or Spotify. Because we believe that when employees thrive, your company thrives too. Again, visit morganstandley.com/investedatwork to listen today.