Saving for retirement can be confusing. Many people simply choose to let their employer or a financial advisor set up a retirement account. Then, they can blinding make monthly deposits and hope for the best. This will lead to a decent retirement for most people. However, there are other alternatives.
If you are employed and have a retirement program as part of your benefits package, you may or may not have a Roth IRA. A Roth IRA (Individual Retirement Account) is different from most retirement savings accounts. Unlike a standard IRA, money invested in a Roth account is not tax deductible. However, money taken out of the account is not taxed. So the benefits are not seen at first, but can be substantial over time, at least in terms of taxes.
Financial experts who favor Roths give these reasons for their attractiveness…
Interest can be compounded several times over before retirement as long as the account is opened early enough. So even less risky investment can bring a doubled or tripled return to the investor to use tax free for retirement. If you are able to invest your money skillfully, any financial gains made can be used tax free. So, while the amount of money that you can invest into the accounts is limited, the amount you make (and can subsequently withdraw) is not limited. Skilled investors can create great wealth, which can then be utilized tax free after retirement.
For younger people, there is uncertainty about what the tax rate in the US will be in the future. It could be lower than it is now, or it could be higher. Since withdrawals made from Roth accounts after retirement are tax free, any uncertainty about tax rates is taken out off the equation. In contrast, traditional retirement accounts are not taxed up front, but the account holder will be forced to pay taxes on any money withdrawn after retirement.
Current contribution limits are $5,000 per year for those 49 and under and $6,000 per year for those over 50 years of age. This limits the amount that can be earned, but, considering the potential for compounding interest, an account, started early enough in one’s career, should lead to significant post retirement comfort, especially if it is combined with other retirement accounts.
There are a few ways that you can benefit from this type of IRA before retirement. Current rules allow users to make a one time withdrawal to fund the purchase of a new home. This only works for first time home buyers. However, the owner of the account can give the money to a direct descendant (son, daughter, grandchild) to use as long as they are a first time homebuyer.
A Roth IRA can be used even if a person has another retirement account. This means that an account can be set up outside of work and can be used to supplement income disbursed after retirement. The maximum deposit rules do not change for those who have another retirement account. So savvy retirement savers can off-set the taxes they have to pay on the money deposited in the Roth account by depositing money into a SEPs or traditional IRA. Deposits into these traditional accounts are tax deductible up front. Meanwhile, the earnings from the Roth account can be withdrawn tax free after retirement. Ideally, they can be used to off-set the taxes that will be owed on any withdraws from traditional accounts.
Because of the deposit limits, making a Roth IRA the center of your retirement savings strategy will only work if you are still younger (under the age of 40, perhaps). Older investors can still benefit from the Roth’s tax free earnings, but probably need other types of accounts to sustain themselves after retirement.
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