Our last column covered an introduction to 401(k) accounts and Roth 401(k) plans that require an employee to pay income tax immediately on contributions. Today, we will be discussing an account that is quite similar to the 401(k), the Roth Individual Retirement Account, or IRA.
An IRA is a retirement service that offers significant tax advantages. Like 401(k)s, there are two types of IRAs, traditional and Roth. The main difference between the two is that each provides different tax benefits, either tax deduction in the present or tax-free withdrawals later.
With a traditional IRA, yearly contributions are tax-deductible, meaning you will receive a tax break over the years through which you contribute to the account. However, you will eventually need to pay taxes, and this will happen during retirement withdrawals.
Roth IRAs, on the other hand, offer taxable yearly contributions but then tax-deductible retirement withdrawals.
Based on personal circumstances, you may prefer one account type over another. It is likely that this will have to do with whether or not you believe your tax rate will be higher or lower during retirement. If, for example, you have a high tax rate now, maybe you opt for a traditional IRA and receive tax benefits now. If the opposite is true, maybe consider a Roth IRA.
That being said, predicting tax rates is incredibly difficult, so many professional advisors suggest contributing to both accounts in order to diversify savings. There are some limits to eligibility however when considering optional 401(k)s or level of income. However, as college students, it is likely these considerations will come further down the line.
What is most important right now, is to know that both accounts can help maximize retirement savings with tax benefits and to start contributing early and often to one or the other.
An article published in the New York Times encouraged retirement planning in high school. And results show that someone contributing the maximum annual amount to an IRA at age 15 would have more than $2.4 million at age 65; assuming an annual return rate of 7 percent. However, if that person waited to begin saving until age 25, the total at age 65 would be about $1.2 million. So, try to get started as soon as you can!