By mid-2022, over 40% of US households had already recognized the value of Individual Retirement Accounts (IRAs) in their financial planning. Thinking of joining them? You might position yourself for a more secure retirement. One of the big perks of IRAs is their attractive tax breaks that can help your savings grow.
But remember, not all IRAs are the same. You can choose between an IRA savings account, an investment account, or a combination. In this article, we’ll unpack the nuances of each option, helping you make an informed decision for your retirement future. Let’s begin.
What is an IRA Account?
An IRA, or Individual Retirement Account, is a tax-advantaged savings account designed to help individuals save for retirement.
There are two main types of IRAs: Traditional and Roth. Let’s take a closer look:
- Traditional IRA: This plan allows you to contribute pre-tax dollars into your retirement account. Your contributions grow tax-free until you make withdrawals in retirement. To be eligible for this account, you must have an earned income.
- Roth IRA: In this retirement account, you contribute after-tax dollars, and your investments grow tax-free. Qualified withdrawals in retirement are entirely tax-free. To be eligible for a Roth account, you must fulfill specific requirements, including meeting the income restrictions.
Both traditional and Roth retirement plans share the same annual contribution limit. $6,500 for those under 50 and $7,500 for those aged 50 and above.
This table shows how traditional vs. Roth IRAs compare against each other.
|Contributions may be tax-deductible.||Contributions are not tax-deductible.|
|Withdrawals are taxed.||Qualified withdrawals are tax-free.|
|Anyone with earned income can contribute, subject to income limits for tax deductions.||Subject to income limits, but there are no age restrictions for contributions.|
|Required Minimum Distributions (RMDs) usually begin at age 72.||No RMDs during the account holder’s lifetime.|
|Early withdrawals are subject to penalties.||Contributions can be withdrawn penalty-free. However, early withdrawals may incur penalties and taxes.|
As you can see, each type offers distinct features and trade-offs, enabling you to customize your retirement savings to match your situation.
IRA Savings and Investments
Now that you know what an individual retirement account is, exactly what is an IRA savings account, and how does it differ from investing in an IRA?
IRA Savings Accounts
An IRA savings account is a flexible way to diversify your nest egg savings to include safer, lower-risk options. Once you have built up your nest egg here, you can explore options like certificate of deposit (CD) accounts for better interest rates.
So, IRA savings vs. IRA CD, which is best for you? Both are good as low-risk plans; however, with a certificate of deposit, you secure a guaranteed return by agreeing to keep your money deposited for a specific duration. This return is unaffected by stock market fluctuations.
The key distinction between the savings IRA account and investments is also in the level of risk involved. Savings provide a secure place to park your retirement savings while earning interest or dividends.
In contrast, IRA investments offer a broader range of options, including riskier ones that may yield higher returns. Both savings and investments come with their unique advantages and disadvantages.
|Individual Retirement Account||Savings||Investments|
|Benefits||Lower risk.||Potential for higher returns.|
|Tax-advantaged savings.||Tax-deferred or tax-free growth.|
|Steady interest/ dividend income.||More investment choices.|
|Easy to manage and understand.||Tailor your portfolio to your goals.|
|Drawbacks||Lower Returns.||Potential for market-related losses.|
|Limited potential for retirement wealth accumulation.||Requires some financial knowledge.|
|Does not provide the level of diversification for long-term retirement planning.||Subject to market-related volatility.|
Your choice depends on your risk tolerance, goals, and finances. Many people use both to diversify their retirement savings options.
Investing in an IRA
IRA investment is the more popular alternative to savings. This plan lets you invest your retirement money in various options, including stocks, bonds, mutual funds, and even real estate. This approach also offers many advantages—tax benefits, positive IRA growth potential, and diversification opportunities.
Investing is also relatively straightforward.
- Determine the suitable retirement account for your needs and open it.
- Set up contributions
- Invest your contributions into stocks, bonds, index funds, or mutual funds.
- Regularly review and modify your savings investment accounts as necessary.
If you’re unsure how to invest in an IRA or are uncomfortable making financial decisions, contact a financial advisor for an IRA for professional guidance.
Do IRA Accounts Earn Interest?
The beauty of individual retirement accounts is the potential to earn interest on your money, but how interest is handled differs for Traditional and Roth plans.
In the Traditional plan, contributions are often tax-deductible, and earnings grow tax-deferred. This means you won’t pay taxes on the interest until you withdraw funds during retirement, allowing your interest to compound without annual taxation.
So, does the Roth IRA earn interest, too? Absolutely. Qualified withdrawals, including earnings, are tax-free. While both types can earn interest, the key difference lies in when you pay taxes, making Roth advantageous for those expecting higher tax rates in retirement, while Traditional accounts offer upfront tax benefits.
It is essential to point out that the interest earned depends on your investment decisions. Unlike traditional savings accounts with fixed interest rates set by the financial institution, traditional and Roth IRA interest rates are influenced by the performance of your chosen investments.
IRA vs. Brokerage Account
If you’ve already been doing regular investing, chances are you use a brokerage account.
A brokerage account lets you buy and sell various investments, offering control and flexibility. Individual retirement accounts are tailored for retirement savings, enabling you to contribute a portion of your income and invest it for future growth.
A significant benefit of investment in IRAs is the potential tax savings we discussed. Standard brokerage accounts lack the tax advantages of IRAs and may incur capital gains taxes on investment profits.
If you’re saving for retirement and want to enjoy tax benefits, opt for an individual retirement account. A brokerage account may be a better fit for flexibility and immediate access to funds.
Choosing the Right Individual Retirement Account
How can you tell which is the best IRA to use? Selecting the correct type of individual retirement account depends on your unique financial situation and goals. Here are some key considerations:
- Opt for a Traditional IRA if you seek immediate tax deductions, or go with Roth for tax-free withdrawals in retirement.
- Consider the IRA tax implications. If your current tax bracket is high and you expect it to drop in retirement, a Traditional IRA may be more advantageous. Conversely, if you’re in a lower bracket now, Roth might be more beneficial for tax-free withdrawals later.
- Be aware of the IRA contribution limits. Exceeding these limits can result in penalties.
- Traditional plans mandate required minimum distributions (RMDs) starting at age 72, while Roths have no RMDs during your lifetime.
- Roths can offer tax-free inheritance to your beneficiaries, making them a valuable estate planning tool.
Remember. It is essential to consult with a financial advisor or professional agency like Interactive Wealth Advisors to analyze your specific circumstances and help you make an informed decision.
Hopefully, this guide has provided insights into the difference between savings and investing in IRAs. To quickly recap, IRA savings is a secure way of managing retirement funds, often with potential tax benefits, while IRA investments carry the potential for higher returns but also involve more risk.
Your choice between these retirement income strategies should align with your unique financial situation and goals. Whether you lean toward a conservative approach or are open to greater risk for the prospect of higher gains, seeking professional guidance is crucial. Collaborating with a knowledgeable advisor can help you navigate the intricacies of retirement investment accounts and make informed choices that pave the way for a secure and prosperous retirement.