The IRA is the best financial tool widely available to just about all of us. As we’ve discussed before,the traditional option of a pension is quickly becoming a fairy tale, or not even an option in some industries.
An IRA can be opened with numerous companies, in fact, you name them, they probably offer it. The basic principle behind the account is to add a portion of your income to some sort of investment vehicle like stocks, bonds, index funds, exchange traded funds, etc. and have your earnings grow tax deferred until you are ready to withdraw them at retirement. There are two basic types of IRA, a traditional and a Roth.
The two accounts are very similar. They both offer tax deferred growth on your money, which allows it to grow faster than if you were to pay taxes on your profits. Both accounts offer the same investment types as well and both accounts charge a penalty of 10% value on any funds withdrawn before retirement(59 1/2 years old).
The main difference between the accounts is how the taxes and contributions are handled. When contributing to a traditional IRA you pay taxes on the income as normal but have certain tax advantages and write offs in return . With a Roth IRA Qualified withdrawals are taken tax free. Deciding between the two is both a matter of personal opinion and income levels. Certain income levels allow for more tax breaks up front with the traditional IRA, but if you don’t qualify for the tax benefits, you’re better off in a Roth. You can check with the IRS to determine this years limits.
If you’re lucky enough to land yourself a full time job in this economy of ours, then by all means start contributing to your companies 401K plan right away. There are a few options that companies can give their employees for these plans, but for right now lets stick to the basics. Let’s go over a traditional 401K plan.
The traditional 401K is a set up by the company for which you work. They choose a series of investments, usually index or mutual funds of varying risk levels, and create their plan from them. You as the employee are eligible to contribute your pre-tax dollars to this plan and if the company offers a matching program, you are not taxed on their contribution either. (limits are $15,500, or $20,500 if you’re over 50–Thanks Joe*)
So let’s say your pay is $100 per week and you decide to contribute 10% of your pay. Let’s further assume you work for Awesome corp, who is willing to match your contributions by 50%. Each week, you earn $100, then pay out $25 dollars to taxes and you end up with $75.
If you contribute the 10% instead, you earn the same $100 but $10 goes to your 401K account first, then Awesome corp adds another $5 making it $15 added to your 401K. Then you are taxed on the $90 you earned and pay out $22.50 this week, leaving you with $67.50.
So what you have here is a take home pay of $7.50 less than you would have if you didn’t contribute, but you’ve gained $15 in investments which brings your overall pay to $90 instead of $75. In the end you pay less taxes, get more from your company in return and take a very small hit to your cash on hand. I call that a win -win.
All contributions are pretax, you don’t pay any income taxes on the money until you withdraw it. What this means for you, is that you have more money to add to the account and more money in means greater earning potential for you. When you withdraw the funds at retirement you are taxed at the current income tax bracket you are in at the time. This is what they call a tax deferred investment. I can’t stress enough how important this product is to anyone looking to retire in comfort. Find out what your company is willing to match and max out your earnings by taking advantage of every penny. If they offer a match up to 10% and you can afford it, do it for as long as possible. If they offer a match up to 1%, do that too. A good rule of thumb here is to contribute only what they will match, so every dollar you add earns more, anything past that could be better used in other investments.