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.1
- Roth IRA: Contributions are made with after-tax dollars, so you pay taxes up front. But your money grows tax-free and withdrawals are tax-free after age 59½, if you’ve had the account for at least five years.2
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 benefit 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:
- Most employers offer some form of match on employee 401(k) contributions–that’s free money you shouldn’t pass up.
- 401(k)s have generous contribution limits that usually come out of your paycheck on a pre-tax basis ($19,500 for tax-year 2021, plus a $6,500 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 2020 and 2021, you can contribute up to $6,000 to a traditional IRA (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 put you miles ahead of where you would be if you only put money in a taxable account,” says 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 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.
#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 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.
#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). When it’s time to take your money out, you’ll have the flexibility to tap the account that makes the most sense for you. And this may help you manage your taxable income and how much tax you owe in retirement.