In this article, I’m going to teach you about one of my favorite tools to building wealth called Individual Retirement Accounts "IRAs".

This information will not only help you secure your own financial future, but the financial futures of your loved ones as well.

So if you want to retire wealthy, and you don’t want to die typing on a keyboard in a cubicle, then read this article.

What Are IRAs?

“IRA” stands for Individual Retirement Account.  

They’re “Individual” because they’re related to an individual as opposed to 401(k)s which are employer sponsored programs.

The word “Retirement” refers to the fact that they are tax-advantaged accounts designed for building retirement savings.

The word “Account” means they are a place to hold your investments. They are not investments in and of themselves. Just like a checking account isn’t money, it’s a place to hold your money.

The two most popular types of IRAs are Roth IRAs and Traditional IRAs

Roth IRAs

In case you’re wondering, “Roth” stands for, well, Roth. Seriously, it was named after William Roth a former senator from Delaware. 

The defining characteristic of Roth IRAs are that you contribute money that you’ve already paid taxes on. 

Your money grows tax free in your Roth account.

Later, when you decide to withdraw your earnings you don’t have to pay taxes on your earnings so long as you meet both of the following two conditions:

1. You are older than 59.5
2. Your Roth IRA is at least 5 years old.

If you withdraw your earnings before you’re 59.5, generally you’re going to have to pay a 10% penalty on your withdrawal. 

Some exceptions apply such as using the withdrawal from your Roth IRA for a first-time home purchase — up to a $10,000 lifetime limit. 

No matter your age, you will be taxed if you withdraw your earnings before your Roth IRA is at least 5 years old. This is true even if you're older than 59.5. (1)

Keep in mind that everything I’ve said about withdrawals relates to withdrawing earnings. You are allowed to withdraw the principal amount you’ve contributed to your Roth IRA both penalty and tax-free at any time. (2)

So let’s say you opened a Roth IRA last year, you contributed $5,000 to it and since then the investments you made earned $1,000 in profit. You can withdraw the $5,000 principal you contributed at any time, penalty and tax free. 

So with a Roth IRA you defer your tax benefit. 

You're effectively saying "I don’t want my tax benefit now I'm saving it until I'm older than 59.5".

When would you want to do this?

In the United States, the federal income tax system is progressive, so the rate of taxation increases as income increases. Marginal tax rates range from 10% to 37%.

So if you think your tax burden now is lower than what it will be in retirement it makes sense for you to contribute to a Roth IRA, pay taxes now at the comparatively lower tax rate and when you're in retirement and should be in a higher tax bracket, you won't owe any taxes.

Consider the following analogy:

Let’s say I offer to pay your heating bill for two months in a year. Which months are you going to choose? Are you going to choose June and July? If you’re in the northern hemisphere, probably not. You’re going to choose the colder months in which your heating bill is the highest. So something like December and January. 

Similarly, when you're choosing an IRA you want to choose one that offers a tax advantage at the time when you think your tax burden is going to be the highest.

So let’s say you’re young, you’re just starting your career, your income is low and you only pay 10% in income tax. Chances are you're going to be in a higher tax bracket when you're 59.5. Accordingly, it's likely a good idea for you to contribute to a Roth IRA and pay taxes on your contributions now so that you can pull them out tax free when you're older than 59.5. 

What if you expect that you are in a higher tax bracket now than you will be when you retire?

In this case, it likely makes sense for you to contribute to a Traditional IRA.

Traditional IRA

With a Traditional IRA you get your tax benefits upfront.

You can make your contributions to a traditional IRA with pre-tax money.

Just like a Roth IRA, your money grows tax free in your account.

Taxes are due upon withdrawals. (4)

So to summarize the primary differences in tax treatment between Traditional and Roth IRAs:

For many, it may not be clear whether to use a Roth IRA or a Traditional IRA, in which case it makes sense to diversify your tax risk by contributing to both a Roth and Traditional IRA.

I personally favor traditional IRAs more than Roth IRAs simply because with a traditional IRA you've secured your tax benefit because you've received it upfront whereas with a Roth IRA you hope to get a tax benefit in the future but there’s always the risk of legislation being passed that changes the tax benefit or eliminates it altogether.

How Much Can You Contribute to IRAs?

By law, there are limits to how much you can contribute to an IRA in any given year.

As of 2019, you can contribute up to $6,000 total to IRAs if you are below the age of 50 and $7,000 if you are above the age of 50.(4)

Can I Contribute to IRAs If I Have a 401(k)?

Absolutely. 401(k)s are employer sponsored retirement plans and they too can be traditional 401(k)s or Roth 401(k)s. (5)

One of the primary differences between 401(k)s and IRAs are their contribution limits.

The basic employee contribution limit for 2019 in a 401(k) is $19,000.

Any contributions you make to other types of retirement accounts, such as IRAs, do not affect your 401(k) contribution limit.

So you can contribute $19,000 to your 401(k) and still contribute an additional $6000 towards your IRAs.

If you are 50 or older, you can kick in an extra $6,000 “catch-up contribution” for a total of $25,000 towards your 401(k).(6)

Which Plans Should You Fund First?

I guess I should mention here my disclaimer which is that I am not your financial adviser. Consult with one and do your due diligence before you make any decision.

What I generally advise is the following:

If your employer matches your contributions to your 401(k) then make sure you maximize your employer's match.

E.g. if your employer offers to match all your contributions up to 3% of your salary, then go ahead and make sure you’re contributing at least 3% of your salary to your 401(k). The employer match is free money and we want to make sure we get all of it.

This is of course assuming you're able to find ethical investment options in your 401(k) plan that you think are Halal and are comfortable with investing in.

After you max out your employer's contribution, then max out your contribution to your IRAs.

The reason I want you to do this is because 401(k) plans often provide a limited number of investment alternatives that may not correspond with what you'd like to invest in and may carry expense ratios that are too high.

When you contribute to your IRA you have complete freedom to choose the investments with the lowest expense ratios, most closely correspond with your investment objectives and are most in-line with your ethical considerations.

After you’ve maxed out your IRA contributions, go back to your 401(k) if you still have contributions you’d like to make and max that out.

Can IRAs Make Me a Millionaire?

Absolutely.

Let’s say you want to retire at 65, with $1,000,000 in today’s dollars in your retirement savings.

Now, how much do you need to save in order to get to $1 million in today’s dollars at age 65.

A good estimate for return from the stock market yearly is 8%. Let’s take 2% inflation out of this number in order for the $1 million we calculate to be in today’s dollars. So now our estimate for the growth of our investments becomes 6% every year.

Below is how much you need to save starting at different ages to reach the $1,000,000 mark at age 65.

The road to a $1 million in today’s dollars at age 65

How to read the table: if you have 0 savings today, you’ll need to invest ~$4,300/year = ~$360/month = ~$90/week to have $1 million dollars in today’s money when you’re 65.

This handy calculator was used to populate the table above.

So you see from the table, the more you wait to start saving, the more you have to contribute and the more difficult getting to the million becomes. The earlier you start saving, the more you can take advantage of compound growth of your investments.

This is why it’s important for you to start now and if you have kids, get them to start early too.

When you’re done with this article, open another tab and search best places to open an IRA and set up automated contributions that will get you to whatever your retirement goal is when you want to retire.

Don’t tell yourself, once I start earning more I'll start planning for retirement. Expenses have a habit of expanding until they occupy the budget you allow for them.

Consider whatever you need to save from your paycheck in order to retire comfortably at the age you want to retire is money that you no longer earn.

If you’re 30 and you need to save $8,400 a year to reach your goal of $1 million when you’re 65, consider that you just took an $8,400 paycut. If you are earning $100,000 annually you now earn $91,600. If you are earning $50,000, you now earn $41,600. You have to make due with whatever your new pay is. The rest of your salary goes automatically into your retirement savings and doesn't exist until you're 59.5.

Let me know what steps you took to start planning for your retirement in the comments below. I’d love to hear about your story and if I was able to influence you to start planning for retirement, make my day and please do share.

Sources

(1) https://www.hrblock.com/tax-center/irs/tax-responsibilities/early-withdrawal-penalties/

(2) https://www.schwab.com/ira/roth-ira/withdrawal-rules

(3) https://smartasset.com/taxes/income-taxes

(4) https://www.irs.gov/retirement-plans

(5) https://www.nerdwallet.com/blog/investing/traditional-ira-rules/

(6) https://www.investopedia.com/retirement/401k-contribution-limits/