The first step in understanding retirement is being able to answer the age old question…what does IRA stand for? The answer, individual retirement account!
If you are in your 20s and you don’t have an IRA yet, shame on you! Just kidding, it’s never too late to start planning for retirement but sooner is better than later if you want to have a pleasant retirement. Ideally, as soon as you start to earn an income, you should open an IRA, and in particular a Roth IRA. Most likely when you first start to make money, you are in a low tax bracket. But I’m getting ahead of myself. Let’s start with the basics of a Roth IRA.
What is a Roth IRA?
An IRA is an individual retirement account. The government knows that it can’t possibly give out money to everyone upon retirement so it is rewarding those who decide to save on their own with tax breaks. The two most talked about IRAs are the Traditional IRA and the Roth IRA. The major difference between the two are the tax differences. A Traditional IRA allows you to save money now and pay tax on it later. A Roth IRA allows you to save money that you have already been taxed on and withdraw it tax free later. There are a few other benefits and differences to both, but that is the main difference.
Why Should I Open a Roth IRA?
If you are in the early stages of your income earning life and you expect your taxes to increase in the near future, you should be putting away money in your Roth IRA. When it’s time for you to retire, you will not have to pay taxes on that withdrawal because you’ve already paid your taxes. If you have been working for a while and you are at the height of your career, you probably don’t want to contribute to a Roth. Why? You are most likely paying the most taxes that you will ever pay, and deferring the taxes until you retire and you are in a lower tax bracket would probably be better. This is the time in your life when you would want to switch over to a Traditional IRA.
Investing in a Roth IRA
My favorite feature of the Roth IRA is the tax free earnings possibility. Let’s say that you contributed the max for this year, which is currently 5,000 dollars. You decide to buy some shares of a dividend paying stock that increases in value almost each year. Let’s say that it grows at 5% each year. When it’s time for you to retire in 45 years, that one deposit has grown to $44, 925 dollars. Guess how much taxes you have to pay on the 44k? Absolutely nothing. The best feature of a Roth IRA, in my opinion, is the ability to withdraw your investment earnings tax free! You’ve already paid taxes on the contribution and you don’t owe anymore. Pretty sweet, huh?
Do you have a Roth IRA? And if you are in Canada, is there a similar retirement account?
Disclaimer: I am not a tax professional, nor am I a financial advisor. Please consult a professional for your particular situation.