Once you enter the job market and get hired, think seriously about directing part of your income to retirement savings. Some companies offer a retirement savings plan for employees; others don’t. Either way, you can set up your own retirement plan account and make contributions. This type of arrangement is known as an individual retirement account, or IRA. IRAs come in two basic types:
- Traditional IRA. With a traditional IRA, your money—both the amount you invest and what your investments earn—is not taxed until you withdraw it in retirement. If you withdraw money before age 59½, you must pay taxes on the amount you withdraw, plus a penalty. You may avoid paying this penalty under certain circumstances—for instance, if you qualify to apply the money to a home purchase.
Furthermore, when you put money into a traditional IRA, you may be able to deduct the amount from your taxable income. (Tax-deductibility of your contribution depends on your income and tax-filing status, and whether you're covered by a retirement plan at work.)
- Roth IRAs. With a Roth IRA, you do pay taxes on the money you invest in your account. However, you don't pay taxes when you withdraw the money in retirement. You will not incur a penalty for withdrawing your contributions early from a Roth IRA. However, you will have to pay a penalty (and taxes) on any earnings you withdraw before age 59½.
Choosing the Best Plan for You
Choosing the best IRA plan is an individual decision. Only you can choose the plan that's right for you. If you're deciding between a traditional and a Roth IRA, consider these factors:
- Tax deductions. A traditional IRA may provide you with a tax break on your income each year you contribute to it, whereas a Roth IRA will not. If you need the tax deduction now, a traditional IRA may help reduce your taxable income. If you’re a single taxpayer and aren’t covered by a workplace plan, your traditional IRA contributions are fully deductible.
- Income limits. You can contribute to a traditional IRA regardless of your income level. Not so with a Roth IRA. In 2011, single tax filers could make full contributions to a Roth IRA only if their modified adjusted gross income was less than $107,000. If your taxable income exceeded that limit, a traditional IRA was a better option.
- Retirement expenses. You don't have to pay taxes on the money you withdraw from a Roth IRA. With a traditional IRA, you pay taxes when you take out the money. If you expect taxes to be higher by the time you retire, you may want to opt for a Roth IRA so that you’ll pay owed tax sooner rather than later. Also, you can leave your money in a Roth IRA for as long as you want. In contrast, with a traditional IRA you’re required to take out a minimum amount from your account yearly, starting at age 70½. (The amount is based on IRS “expected life span” charts.)
- Early withdrawals. You will not be penalized for early withdrawals of contributions you have made to a Roth IRA. Unless you meet certain criteria, you will be penalized—10 percent—on any withdrawals of contributions you have made to a traditional IRA before you turn age 59½. If you think you'll need early access to your savings, a Roth IRA may provide more flexibility for withdrawals.
Getting the Best of Both Worlds
You can hold both a traditional IRA and a Roth IRA at the same time. If you wish to gain the benefits of both accounts, you can split your contributions between the two. The contribution limit for any given year applies to both
accounts, so you will need to adhere to that maximum contribution limit. In 2011, the maximum IRA contribution limit was $5,000 for people under age 50. So, if you had both types of IRAs, you could contribute to each of them as long as the combined total didn’t exceed $5,000—say, $2,000 to one and $3,000 to the other.
Setting up Your Plan
You can establish an IRA through a bank, an investment company, and even a discount broker. Different companies set different fees and initial deposit requirements. Shop around to compare options before opening an account.