Individual Retirement Account
An IRA or Individual Retirement Account is a tax sheltered retirement account set up outside of a employers program or rolled over from an employers program.
These accounts are held by brokerage firms and allow your money to grow tax free until retirement.
The advantage of these accounts is the assumption that your tax rate will be lower in retirement. Upon withdrawal, you should be in a lower tax bracket.
What does this mean to you, Dear Reader? It means that you should be employing this strategy in your own financial life!
Using tax advantaged accounts(401k,403b,IRA) allows us to avoid taxes for a long period of time and that money compounds unimpeded. Once we do withdraw funds, hopefully at age 59 1/2 or older, we can control how much we withdraw to control the tax burden. Do not withdraw funds before 59 1/2 or you’ll incur a penalty.
On the other end of the spectrum, we have a Roth IRA, which allows us to put after tax money into an account and allow that to grow tax free.
The government(U.S.) states that this money has already been taxed, and once placed in the Roth IRA, it is allowed to grow and compound tax free, even upon withdrawal! Roth IRA’s are great if you expect to be in a higher tax bracket after retirement.
The government does put limits on how much you can place in these accounts. In both IRA’s and Roth IRA’s, you can only put $5500 dollars per year into the account. The two exceptions to this rule are rollovers(from 401k or 403b) or if you are over age 50, in which case you can contribute $6500 per year.
The over 50 contributions are raised to allow you to “catch up” because you are closer to retirement age.
Invest in IRA’s First
We should always take advantage of these tax sheltered accounts first when planning for our retirement. While $5500 doesn’t sound like a lot, starting early and putting this money away tax free will compound to astronomical amounts.
Check this out:
Never underestimate the power of compounding!
The example above is accomplished by depositing $5500 a year for 30 years at an average return of 8%. The market has historically averaged about 8% since 1900.
Hopefully you can see the power of investing in one of these accounts.
Employer Sponsored Account First
If you are gainfully employed with an employer who offers a 401k account with matching funds, you should be applying enough there to get the full match before investing in an outside IRA.
For example, if your employer offers a 50% match up to 6%, that means for every 6% you put in, they will match with 3%. That is free money just for using their account! We don’t want to forego this free money because it will compound just like our own.
If for some reason you leave this employer in the future, you can then rollover this 401k account into an IRA and let the money continue to grow tax free.
That is why rollovers are an exception to the $5500 per year rule. If you have $50,000 in your 401k at the time of your separation from your employer, you are allowed to roll that amount into the IRA of your choosing.
Take advantage of what your employer offers first, and then focus on an outside IRA. Utilize every tax advantaged account you can.
Where to Invest
If you would like a an easy way to get started, check out M1 Finance.
If your employer doesn’t offer Vanguard, they should still offer some form of Index Funds(eg. S&P 500 or Total Market).
Have you already begun using an IRA, or are you still researching your options? We want to hear from you, and we look forward to the conversation! Stay tuned for more updates on our Journey to Freedom as well!