Are misunderstandings about IRA accounts keeping you from financial security? Money Girl covers 3 of the most common mistakes that may be preventing you from using IRAs to build wealth.
But here’s the power of making small investments over time: If you contributed $100 a month for 40 years with a 7% average return, you’d amass over $260,000. And if you contributed the current IRA maximum of $5,500 per year instead, you’d have over $1 million!
So don’t worry that opening an IRA could cause a financial hardship down the road if your situation changes and you can no longer make contributions. Whether you add money to a retirement account or not is completely up to you.
Also see: 10 IRA Facts Everyone Should Know
Mistake #2: Getting Stuck on the Type of Account to Open
There are 2 main types of IRAs for individuals: a traditional and a Roth. I see many people get into “analysis paralysis” about the differences between them, and end up doing nothing to achieve their financial goals for retirement.
Here are the major differences:
- A traditional or regular IRA allows you to make contributions that are generally tax-deductible. Neither the money you put in nor earnings in the account are taxed until you take distributions.
- A Roth IRA does not allow tax-deductible contributions; you must contribute on an after-tax basis. However, there’s never any additional tax on contributions or earnings in the account. In other words, your distributions are completely tax free.
You can see a side-by-side comparison of the full list of IRA rules at IRS.gov.
Additionally, to contribute to a Roth IRA you can’t earn over a certain amount. Here are the Roth IRA income thresholds by tax filing status for 2015:
- Married filing jointly or qualifying widow(er): your modified adjusted gross income must not be $193,000 or greater.
- Single, head of household, or married filing separately and living separately: your modified adjusted gross income must not be $131,000 or greater.
- Married filing separately but living together: your of modified adjusted gross income must not be $10,000 or greater.
So what happens if you open up a Roth IRA, but later earn too much to qualify for it? No big deal. You keep the account as-is, but can’t make any new contributions to it.
It’s kind of like hitting the pause button on being a contributor, but you still own the account. You never lose any money, tax advantages, or control over a Roth account.
If you’re eligible to contribute to a Roth IRA, it’s the best choice if you believe that your tax rate is lower today than it will be in retirement.
Not qualifying to contribute to a Roth IRA because your income is too high is a terrific problem to have! And in the future, if the limit goes up, or your income goes down below the annual allowable amount, you can start making Roth IRA contributions again to the same account.
Should I Have a Traditional or Roth IRA?
If you’re eligible to contribute to a Roth IRA, it’s the best choice if you believe that your tax rate is lower today than it will be in retirement. If that’s the case, paying tax upfront on Roth contributions will save money compared to paying a higher tax rate on distributions from a traditional IRA in retirement.