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Now back to our discussion on retirement.
Today we are starting to look at specific retirement accounts that you can open up. Each week I’ll cover a different account by explaining what that account is, how to choose the right bank for that account, any positive or negatives associated with that account, and how you might use this account.
After I’ve gone over all the different accounts you can have, I’ll do a big wrap-up of all the accounts so you can really see how these accounts are different and help you make the right decision about what account to open up.
What is an Individual Retirement Account?
Our first retirement account is the traditional Individual Retirement Account, also known as an IRA. Do not confuse this with a Roth IRA or other IRAs. We will cover the Roth IRA next week. Today is just the traditional IRA.
There are retirement accounts that you open through work and there are retirement accounts that you open yourself. An IRA Is one that you open yourself.
An IRA is an account that allows you to contribute pre-tax dollars into a retirement account where you can make investments. Your money will grow tax-deferred. Unlike other investment accounts, you will not pay any taxes on your growth while you are still contributing to this account and not withdrawing the money you have put in. However, once you start to withdraw the money you have contributed in retirement age, you will have to pay taxes. You can start withdrawing money from your Traditional IRA at the age of 59 ½ or later. So if you start this account at the age of 20 you will not be able to withdraw any of the money you have put in until you are at least 59 ½ and you will pay taxes on what you withdraw.
When you are contributing to a Traditional IRA you have to contribute earned income. You cannot start this account unless you have a job that gives you a paycheck. If you have a job where you get a paycheck, you can contribute to a Traditional IRA, but there is a contribution limit. You can only put in $6,000 pre-tax dollars each year. This is the limit in 2021. Some years it will go up, so make sure you are always contributing the max amount. If you are 50 years or older, you can contribute $7,000 pre-taxed dollars. There are no income limits for Traditional IRA. You can contribute to this type of account as long as you have an income and it does not matter how much you make. However, if you only earn $5,000 pre-tax, you can only contribute $5,000 into your account.
With a traditional IRA, you are pretty much locked into not being able to touch that money until 59 ½ years old. However, if you really need to withdraw before retirement age you will have to pay a 10% penalty of the amount withdrawn as well as taxes, which are taxed at the standard income tax rates. There are exceptions for withdrawing and not receiving a penalty (you will have to pay taxes though). You can look up these exceptions online.
When you are retirement age and ready to withdraw your account, you will have to pay taxes on any money you take out. You will be taxed at wherever tax bracket you are in, and if you are retired this might be a lower rate than where you were when making an income.
Choosing an Individual Retirment Account
If you want to open up a Traditional Individual Retirement Account there are fewer things that you need to worry about, unlike savings and checking accounts. All Traditional IRAs have to be the same per the IRA standards.
You can open an IRA with any investment company, like Fidelity, Ally Invest, Vanguard, Charles Swab, and so on.
Most of these accounts have no maintenance fees, no minimum amount required to open, and no fees for trading. Some do, but those are very rare nowadays.
I personally use Fidelity for my retirement accounts. I like their platform and it works for me.
There are some obvious positive aspects to starting a Traditional IRA.
The most obvious is that this is a retirement account and we know from previous episodes that starting to save for your retirement is always a smart idea to do at any age!
Aside from that though, a Traditional IRA will have tax-free growth. You won’t pay taxes on any growth from your account. Your money can grow and you won’t pay taxes, unlike a brokerage account.
A Traditional IRA is also pre-taxed income. So you don’t pay any taxes on the money you put in as well, which can be a positive if you earn a high income and are in a high-income tax bracket.
There are some negative aspects to starting a Traditional IRA though.
One is that there are contribution limits. You can only put in $6,000 of earned income if you are younger than 50. If you are 50 years or older, you can put in $7,000 of earned income. If you want to invest more, you will have to open up another account. I believe that even putting in the limit amount is worth it.
A very obvious drawback to this account is that there are penalties for withdrawing your money early. If you are not 59 ½ you cannot withdraw the money you’ve contributed penalty-free. The penalty is 10% of the withdrawal on top of taxes!
When you reach the age of 72 there are mandatory withdrawals. So if you were planning to keep this money until 80 or so, you can’t! That could be a drawback to you.
The biggest drawback for me is that you have to pay taxes when you withdraw your money at retirement age. I did have not paying taxes on the money you put into this is account as a positive, but it can also be a negative thing. Let me explain this some more. If you put in $6,000 in your Traditional IRA today you don’t pay any taxes. If your money grows to let’s say $10,000 then you pay taxes on the $10,000. You pay taxes depending on what tax bracket you are in. When you are retired you will most likely be in a lower tax bracket because your income is going to be low. So you decide at a young age to not pay your higher tax bracket taxes on the $6,000 and you’d rather pay a lower tax bracket taxes when you are retired on your money.
That sounds great, but with the way things are going, we don’t know what taxes will look like in 20,30, 40, or 50 years! Some of you won’t be able to touch this account for possibly 50 years. So do you want to use the tax info of 2021 to make this decision? You might and that’s okay! But you also should know that a lower tax bracket taxes might be exactly what you would have paid right now or even higher when you are of retirement age. It’s a risk of the Traditional IRA and a drawback to consider for yourself. I would personally rather pay taxes now.
How to use
How you use a retirement account won’t be goal-based like other accounts, but more long-term implications for yourself.
If you earn an income and you want to start a retirement account, a traditional IRA is a great place to start. You can only save $6,000 a year and this might be just enough for you. If you have even more money than $6,000 to save I would still open this account and then open another type of retirement account.
We all know that we should open retirement accounts, but there are implications for these. If you don’t want to pay taxes on your income now, then a Traditional IRA is a great option. If you want to pay taxes now on your income, then this might not be the right option for you.
An IRA is an account everyone should have though. It just depends if a traditional IRA or Roth IRA is right for you. Next week I’ll go over Roth IRAs and really compare the two IRAs and why one person might want a Traditional IRA and why another would want a Roth IRA.
Let me know – do you have a Traditional IRA? If you do, what broker do you use? I use fidelity for my retirement accounts. I like their website and that you can buy fractional shares.
Thank you for listening to No Fear Finance, an Amalfi Media show. Make sure to check out the other Amalfi Media content because we have something for everyone! Thank you to everyone for the constant support! If you want to financially support us please go to the link in the show notes or Amalfimedia.com/support.
Until then, have a great week and see you all on Monday.