Welcome to the second part of our retirement planning for millennials series. In part one we discussed taking those first tentative steps on the investing lader. In part two we are going to look at the different options for opening an Individual Retirement Account, better known as an IRA.
IRAs can be quite intimidating for new investors, and the task isn’t made any easier by the numerous options which are available. So before we go any further lets look the two main types of IRA.
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IRAs come in two flavors, traditional and Roth. The main difference between the two comes down to when you have to pay tax. When it comes to the IRS, there’s no such thing as a free lunch, they still expect taxes to be paid on your earnings. You just have to decide whether to pay them now, or pay them later.
Contributions to traditional IRAs are deductible in the year they are made, but you must pay regular income tax when you withdraw the money in retirement. On the other hand, contributions to Roth IRAs are not tax deductible when the contribution is made and you don’t have pay taxes upon distribution.
It’s important to remember that in both cases your money grows tax free while its in the account.
There are a number of other differences as well. While there are no income limits to contributing to a traditional IRA, there are income limits for contributing to a Roth IRA. For the 2014 tax year, Roth IRAs are only available to those earning less than $114,000. Which is a problem if you’ve just landed a prized job at Facebook.
It would be nice if you could squirrell away as much as you wanted each year in order to safeguard your retirement, but you can’t. If such a scheme were available it would be abused by the rich and powerful to defer tax on billions of dollars of earnings.
In 2014 you can make an IRA contribution of up to $5,500 plus a $1,000 catch-up contribution once you are over 50. You are free to use your allowance to contribute to a combination of both a Roth IRA and a traditional IRA as long as the total does not exceed the contribution limit. Also IRA contributions must come from earned income. So you can’t invest your student loan money!
It gets more complicated if you’re eligible for an employer-sponsored retirement plan. If you or your wife are employed by a company that offers an employer-sponsored retirement plan such as a 401(k), you face limits for deducting your IRA contributions.
The deductibility of traditional IRA contributions are phased out as specified income levels are reached. In 2014, your eligibility for a tax-deferred IRA begins to phase out at $59,000 if you are single, and $95,000 if you are married filing jointly.
You can find a full table of deduction limits here. Don’t worry if you are caught out by deduction limits. You can still contribute to a non-deductible IRA, although your non-deductible IRA contributions do not save you taxes in the year you make them, the earnings on them are tax-deferred.
When can you access your money
You can withdraw money from your IRA whenever you want, but be warned, if you’re under 59 ½, you will be penalised. Generally, you cannot take distributions from a traditional IRA before age 59½ without incurring a 10% penalty.
Roth IRAs offer a little more flexible, you may withdraw your contributions to a Roth penalty-free at any time, as long as you don’t withdraw any earnings on your investments (as opposed to the amount you put in) or dollars converted from a traditional IRA before age 59 ½.
There are some exceptions to these rules however, and these are of particular interest to millennials. You can withdraw money from your IRA without penalty so long as you use the funds to purchase your first home or to pay for qualified education expenses.
Which IRA is right for you?
So which IRA is right for you? Well assuming you have a job with a regular income, the first thing to do is assess how much money you can save each month and whether or not you have access to an employer-sponsored plan.
If you do have access to an employer-sponsored plan you need to check the limits for deducting your IRA contributions. This will help you determine whether you need to open a deductible or non-deductible IRA.
The next consideration is your current tax rate, your anticipated tax rate in retirement and your investment timeframe. Assessing your tax rate in retirement is a tricky one, and is basically going to be a guess.
But if you sit down and work out how much you are going to save each year and what you would like your income to be in retirement there are some pretty neat calculators to help you out.
One thing to think about is where you expect your career to go. This can be scary for young people, especially if you have not yet decided which direction your career should take. But as a general rule you should be looking at moving up the pay scale as you get older. No matter what field you end up working in.
As a general rule, if you’re in a high tax bracket now, with a short time horizon you should anticipate being in a lower tax bracket in retirement. If thats the case, a traditional IRA may be your best option.
But for most millennials the opposite is true. You should be in a low tax bracket now, with a long time horizon and look to be in a higher tax bracket when you retire. If thats the case, a Roth IRA is the better option.
What if you need early access to your money?
There are many reasons why you may need access to your retirement savings. But one of the key ones is being out of work. If you have chosen to work in an industry which is notoriously cyclical, like movie VFX for example, there is a strong chance you will spend large periods of time looking for work.
You may have chosen an industry which has a higher chance of industrial injury, increasing the likelihood of spending long periods of time unable to work. A good example would be the oil industry.
These are two extreme examples, but it’s a good idea to think about the long term stability of the industry you have chosen to work in.
If there is a danger of long periods without work, you may need to dip into your retirement savings. In which case a Roth is the best choice because you can withdraw your entire Roth contribution anytime, tax free.
Life after death?
I know, you’re just getting started, why think about death. Truth is you don’t have to, but if you want to bequeath money to your children, even if you don’t yet have any. A Roth IRA is good choice.
Upon inheritance, your heirs will not owe income tax on your contributions or earnings, so long as the Roth was held for at least five years. However, the Roth IRA becomes part of your estate upon death and estate taxes may be due if your total estate exceeds $5.25 million as of 2014.
This far from a comprehensive guide to IRAs but it will give you a good start. You should always take the advice of a financial adviser. Particularly as you get older and your financial affairs become more complicated.
Next time we will talk about what to do with your IRA as you get older. The assets that make up your retirement fund should change as you get nearer retirement. We will look at the different asset classes and which ones should make up your fund.
Remember, you’re never too young to start investing, the earlier you start the better off you’ll be even if you can only afford to put aside a few hundred dollars each year.