Isn't freedom the very thing that is at the center of all of our hopes and dreams? On some level, I think that we all long to wake up every day and do with it exactly as we choose, and for some, that may already be a reality. For the rest, this notion of freedom can feel abstract, a distant thought that we're afraid to believe in for fear that we don't entirely understand how to realize it.
This blog isn't entirely about money. It's also about choices. I absolutely adore having choices. I woke up this morning knowing I had a fair amount of work to do and feeling uncertain about getting it done "on time." This is the sort of thing that has the ability to pull us down emotionally, feeling like we're racing against a clock with too much to do and too little time, but that wasn't my experience. I was elated by the idea of getting to choose where to do my work today. "I'll get up, head downtown early, and go to the tea shop I found yesterday. I can get a tea latte and get some work done. When I need a break I might grab lunch or pop into the bookstore nearby..." I felt aware of the work that needed to be finished, but not stressed out by it. I felt excited to go out and experience my day. When was the last time you felt that way? What would it mean to you if you were able to afford yourself that kind of freedom without being on vacation? How would it feel to wake up and realize that you were going to go to work 100% by choice, not because you had to? How would it feel to wake up every day and choose what that day looks like? Some folks may not dare to dream about days that look like that, other than the ones on vacation, but I believe we can achieve them.
In order to achieve the ultimate financial freedom, we need to secure our mindset first, which is a huge part of what influences this blog, my coaching practice, and my life in general. Closely behind securing our mindset comes debt freedom and a secure traditional retirement. Image it: What would you do with your life if you had no debt and knew for certain that your retirement would already be secure? You wouldn't need to worry about monthly debt repayments. You wouldn't need to sock away hundreds of dollars every month for retirement anymore. You would only need to finance your current needs. If that was your current situation, would you do anything differently? Even if you continue your day-to-day life in the same manner, wouldn't it feel different?
In my own life and journey toward the ultimate freedom, I am currently working to secure my traditional retirement, achieving Coast-FI. The fundamental strategies of living below your means, investing the difference, and so forth are fairly simple. But, a little knowledge goes a long way. Selecting the retirement accounts to best suit our individual needs can really propel us forward in our process. Hence, the current series I am working on, Retirement Savings, where I compare and contrast two different retirement savings vehicles in order to help individuals to educate themselves and select the tool that will work best for them. So, today, we are taking a look at IRAs so that we can compare and contrast the traditional versus Roth option.
IRA stands for "Individual Retirement Arrangement" and was created as a result of the Employee Retirement Income Security Act of 1974 (also known as ERISA). Originally called "regular IRAs," they were first introduced and made available to the public in 1975, allowing people to contribute the lower of $1500 or 15% of their annual income into this retirement savings vehicle while also receiving a tax benefit in the process. This account type was considered revolutionary and one of the best deals out there. Fast forward to 1997, the Tax Relief Act of 1997 is passed and the Roth IRA is born, being named after its chief sponsor, Senator Roth. At this point the "regular IRA" is being called a "traditional IRA," and the Roth IRA gets introduced to the U.S. as the latest, greatest retirement investing vehicle on the scene!
In order to contribute to an IRA, you must have qualified income. This applies to both Roth and traditional IRAs. In general, this means that your income comes from work. Also, you can't contribute more to an IRA than you earned in qualified income (regardless of its annual limit). If you earned less than its annual limit, that's all you can contribute. There is no minimum age for contributing to either type of IRA as long as there is earned income to support the contribution. There is also no maximum age limitation on contributions for a traditional or Roth IRA in 2020 and beyond. This is a change. Before the SECURE Act passed, the age limit for contributing to a traditional IRA was 70 1/2, but has since been changed.
There are income restrictions on Roth IRAs. This is based on your MAGI and varies by filing status. This is also something that should be checked annually for changes. For example, in 2021, a single filer earning $140,000 or more isn't eligible to contribute to a Roth IRA. A single filer, earning under $125,000 can contribute the full amount. A single filer earning between those two amounts is in the phase-out, meaning they can contribute some but not up to the full amount. These numbers are different for people that are married-filing-jointly, and for those married-filing-separately, the income limit is only $10,000. Now, for those earning above the IRS limits for any particular year, there is a bit of a loophole. You can still take advantage of a Roth IRA by making what is called a "backdoor" contribution. If you plan on using this strategy, it would be a wise idea to seek professional help so that you do everything correctly.
In 2021, you can contribute up to $6000 into an IRA. This can be traditional, Roth, or a combination thereof. If you are age 50+ you can increase that by $1000.
Both traditional and Roth IRAs come with tax benefits, but how those benefits are received makes up the primary difference between the two account types. A person using a traditional IRA may be able to receive a tax benefit in the year they make the contribution. I use the word "may" because there are income limitations on the tax benefit associated with the traditional IRA for those that have access to workplace retirement savings plans. But, a person that meets the income limit, can enjoy a tax break in the year of the contribution. The way it works is simple. If they contribute $6000 and are eligible for a full deduction, it will appear on their taxes as if they made $6000 less, therefore, they pay taxes on a lower amount of income.
A Roth IRA works a bit differently. People using a Roth IRA won't receive any upfront tax benefits. They contribute "after-tax" meaning their pay has already been taxed before they contribute, and there isn't a tax break associated with the contribution that they collect in that year. Instead, their money will grow tax-free. This is a huge benefit because later, in retirement, when they take the funds out, no only will they have already paid taxes on the contributions, they also won't owe taxes on the earnings! Tax-free growth is a big deal! This is why people get so excited about Roth IRAs!
Required Minimum Distributions:
When you turn 59 1/2, you may begin taking distributions from a traditional IRA without incurring an early withdrawal penalty. Of course, taxes will still be due. This is because the contributions had been made pre-tax (Remember that tax break from earlier years?). This same age restriction applies only to the earnings portion of a Roth IRA. In order to truly have the Roth IRA earnings be tax-free, you have to wait until the minimum retirement age to take them out. However, since taxes were already paid on contributions, you can take those out at any time.
Users of traditional IRAs are required to start taking distributions by age 72 if they haven't started doing so by then. This used to be age 70 1/2, but was recently increased as a result of the SECURE Act for those born on or after July 1, 1949.
Technically, IRAs aren't set up for people to be able to take loans against. So, that's not really a thing. There are some things you can do. For example, there is a rule with traditional IRAs that allow people to have the money out for 60 days without triggering penalties and such. Honestly, I wouldn't be inclined to try that but if you want to investigate it, make sure you seek professional assistance so that you don't make any errors. There are also special Covid-related provisions that allow people access to their retirement accounts early. With Roth IRAs, loans aren't really needed because you could take out your own contributions without any issue since they've already been taxed. You just need to be really careful that you don't touch its earnings. To be honest, I'm not in favor of raiding either of them early anyway. But, I thought it important to note that they work a little differently so that you can do your homework if you think you might need access to the funds before retirement age.
One of the things I love about using an IRA comes full circle to the idea of choice. Since IRAs aren't directed by your employer, you can open them at any discount brokerage firm you choose and invest your funds in any manner that you please. This can really help you to maximize your returns! I'd love to hear what kind of IRA you use, why you chose it, or any other tips you have about using either Roth or traditional IRAs in the comments below.
For Further Reading:
A Roth vs. Traditional IRA (This one is from 2017, so some of the info is old but the chart in this piece is pretty useful still).