If you’re saving for retirement and are fortunate enough to work for a company that offers a 401(k) – and especially if it provides matching funds – stop reading this article and go do something else. A 401(k) is the best way by far to save for retirement to begin with and if your employer provides matching funds you’re getting free money. And the money tax-exempt until you start withdrawing it at age 55 1/2. You can even borrow money from your 401(k) without incurring a penalty so long as you pay it back within six months.
Traditional and Roth IRAs
If you’re not lucky enough to have a 401(k) you need to start either a traditional or Roth IRA. There are significant differences between the two so it’s important to know what they are. According to an article published on WSJ.com, more people converted into the Roth IRA because of the changes in the law that were passed by the Congress a few years ago. But for the sake of defining the differences, anyone who is earning income and is younger than 70 1/2 can contribute money to a traditional IRA. However, Roth IRAs have some income eligibility restrictions. For example, if you are single you must have a modified adjusted gross income of less than $131,000. If you are married and filing jointly you must have combined modified AGIs of less than $193,000.
Generous tax breaks
Both of these retirement savings plans offer generous tax breaks. But the difference is when you get them. With a traditional IRA the money you contribute is tax deductible on both your federal and state tax returns. However, you are required to pay taxes on the money when you withdraw it. And it will be taxed at ordinary income tax rates. In comparison, when you make a contribution to a Roth IRA you get no tax break but the earnings from your account and your withdrawals are generally tax-free.
Which would be best?
Choosing which of these retirement plans would be best for you will depend on whether you think your income tax rate when you retire will be higher or lower than what you are currently paying. That’s due to the fact that this determines whether the tax rate you pay on your Roth IRA contributions is lower or higher than what you’d pay when you withdraw the money from a traditional IRA in retirement.
Another significant difference between a traditional and a Roth IRA is when you must withdraw the money. With a traditional IRA you must begin withdrawing it in the form of RMDs or required minimum distributions when you reach age 70 ½. Conversely, with a Roth IRA you’re not required to take withdrawals during your lifetime. This means that if you don’t need the money you could let your Roth IRA continue to grow throughout your lifetime and then transfer it to your children when you die and they wouldn’t be required to pay income taxes on their withdrawals.
The federal government recently introduced a new IRA called the myRA. It’s much like a Roth IRA in that you can contribute up to $5500 a year. You can participate only if your income is less than $191,000 if you’re married and filing jointly or $129,000 if you’re filing single. And like a Roth IRA the contributions you make are after-tax and the money is then tax-free when you withdraw it so long as you’re age 59 1/2 or older. And the minimum contribution to a myRA is just $25, which is lower than that for a Roth IRA. You can also withdraw your contributions (but not the interest on them) anytime you wish with no penalty.
Where the similarities end
The big difference between a myRA and a Roth IRA is your investment options. If you go to a brokerage for your Roth IRA you could choose from literally thousands of different index funds, mutual funds, bonds and individual stocks. In comparison, the myRA offers only one investment option – the G fund. The good news here is that unlike other investments, your balance in a myRA never goes down and there is an FDIC-like guarantee. The G fund generally pays more interest than you would get with a savings account but it’s still not a great ROI. For example in 2012 the G fund returned just 1.47%, which isn’t much but is still more than the 1% you could earn with an online savings account.
The most that you can put into a myRA is $15,000. When you reach that amount you must then roll it over into a Roth IRA in whatever brokerage you choose.
The good and not-so-good of myRAs
MyRAs are basically for people that have no retirement plan where they work and could contribute a little bit out of every paycheck towards retirement. The biggest pro of the myRA is that the US treasury backs your investment so it can never lose value. Since a myRA doesn’t require a minimum investment and no fees for opening the account or maintenance, even people on the tightest of budgets should be able to start saving for retirement. In addition, a myRA can be more user-friendly than a Roth IRA because it eliminates the need to choose from a bewildering array of different investment options.
The biggest downside of a myRA is, of course, the rate of return. The only thing you can invest in with a myRA is the G fund. It earns interest at the same rate as money invested in the government securities fund for federal employees. This fund has returned 3.19% annually over the past 10 years. In comparison, people who invested $1000 a year in the S&P 500 index during those 10 years would have earned an average return of 7.67%. What this translates into is that the person who had invested in the S&P 500 index would have made $16,268 while a person who had invested the same amount of money in a myRA would’ve earned $12,861 or $3407 less.
The bottom line
The bottom line for most people is that the better option would be to get a low-cost Roth IRA. As you have seen, the same amount of money invested in it would generate a better return than the myRA even if you invest only in very safe index funds or mutual funds. In the end, having a retirement plan is the most important thing to do. According to CheatSheet.com, 1 out of 3 Americans do not have retirement savings. Do not be part of this statistic and start saving for your retirement. If you have debts like mortgages, auto loans or credit card debts, make sure you work hard to pay this off. Use credit card consolidation to make the monthly payments easier. Not having a retirement fund is bad enough. If you have debt too, that can make things extra hard.