Is an IRA Right for You?

January 5, 2024 Beginner
IRAs can help you build wealth for retirement and potentially get tax breaks, either up front or in the future.

When it comes to retirement, you need to sock enough money away for a comfortable future. But there's also the here and now to consider. IRAs are savings vehicles that can help you build wealth for retirement and potentially get tax breaks, either up front or in the future. There are two main types of IRAs to consider:

  • Traditional IRA: Can allow you to make pre-tax contributions and defer the taxes you owe until you withdraw the money after age 59½. Withdrawals in retirement are taxed as ordinary income; however, if you make any withdrawals prior to age 59½, you may be subject to a 10% federal tax penalty.
  • Roth IRA: Contributions are made with after-tax dollars, so you pay taxes up front. But your money can potentially continue to grow tax-free, and withdrawals are tax-free after age 59½ if you've had the account for at least five years. If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and a 10% federal tax penalty.

Whether either IRA is right for you, or both, depends on your specific situation and goals. Here are five common scenarios in which an IRA could be a good option for you.

1. Your employer doesn't offer a 401(k), or you're self-employed

Employer-sponsored 401(k) plans are called the backbone of retirement savings for two reasons:

  1. Most employers offer some form of match on employee 401(k) contributions—that's free money you shouldn't pass up.
  2. 401(k)s have generous contribution limits that usually come out of your paycheck on a pre-tax basis ($22,500 for tax year 2023 and $23,000 for tax year 2024, plus a $7,500 catch-up if you're 50 or older).

But what if you don't have access to a 401(k) through your employer? In that case, your next best option is likely a tax-advantaged IRA. In 2023, you could contribute up to $6,500 to a traditional IRA, and in 2024, the contribution limit increased to $7,000 (plus a $1,000 catch-up if you're 50 or over).

If you're self-employed, you can also consider another type of IRA called a Simplified Employee Pension or SEP-IRA. These plans allow small business owners to set aside much more for retirement than a regular traditional IRA will allow.

"Whether you're saving in a regular traditional IRA, a Roth IRA, or a SEP-IRA, the tax savings can potentially put you miles ahead of where you'd be if you only put money in a taxable account," said Hayden Adams, CPA, CFP® and director of tax and financial planning at the Schwab Center for Financial Research.

2. You maxed out your 401(k)

Even if you have a 401(k), an IRA might still make sense if you want to set aside more than your 401(k) allows. In that case, a traditional or Roth IRA could help you save even more.

With an IRA, you may also have access to a wider range of investment options, including stocks, bonds, exchange-traded funds (ETFs), mutual funds, certificates of deposit (CD), and more. By comparison, most 401(k)s generally include only a limited set of investment funds.

3. You could use a tax break this year

Contributing to a traditional IRA is one of only a few tax-smart moves you can make right up until Tax Day. As long as you open and fund your account before the IRS filing deadline, your tax-deferred contributions can usually be subtracted from your taxable income. And that might be enough to drop you into a lower tax bracket, reducing what you owe at tax time. However, there are some rules to be aware of when it comes to determining if your contributions will be tax deductible based on your income level and if you or your spouse is covered by an employer plan.

4. Your priority is tax-free growth

On the other hand, if you don't need the tax break now, you might prefer to contribute to a Roth IRA to take advantage of the potential tax-free growth and tax-free withdrawals. Your contributions will be made with after-tax dollars, so they won't reduce your taxable income now. But your money can grow tax-free, which can provide tax savings when you start making withdrawals in retirement.

In addition, if you pass your Roth IRA onto your heirs, their withdrawals will also be income-tax free, making them a tax-efficient way to transfer wealth from one generation to the next.

There are income limitations when it comes to contributing to a Roth IRA, so be sure you check those limits before putting money into a Roth account.

5. You want financial flexibility in retirement

Because they're each taxed differently, traditional and Roth IRAs can be used not only to cut your tax bills in the short term and invest tax-efficiently over the long term but also to give you added tax flexibility when it's time to withdraw your money. This is often called tax diversification.

For example, you could save for retirement in a traditional IRA (pre-tax) and a Roth IRA (after-tax). Keep in mind, though, if you have a tax-deferred account, you're required to take required minimum distributions (RMDs) starting at age 73, so consider taking those distributions first, then decide which account to tap next. Doing so may help you manage your taxable income and how much tax you owe in retirement.

Investors should consider carefully information contained in the prospectus, or if available, the summary prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by calling 800-435-4000. Please read the prospectus carefully before investing.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.