Traditional or Roth IRA?

We have many students come to the SMMC to learn about opening individual retirement accounts, or IRAs. IRAs are basically savings accounts with big tax breaks, which is why they are the best way to save money for your retirement.

NOTE: We suggest that before students start investing, they should consider having at least $500 tucked away in an emergency fund. Additionally, it's wise to pay off any credit card debt before you start investing. If you are going to open an IRA, you want to strive to leave the money in the account until you retire in order to maximize your earnings.

 What is an IRA?

Many people think an Individual Retirement Account itself is an investment - but it's just a basket in which you keep stocks, bonds, mutual funds and other assets.

The money in an IRA grows tax-free. The income from interest, dividends (amount of a company's earnings that is paid out to shareholders), and capital gains (the difference between what you paid for an investment and what received when you sold that investment) can compound each year without being taxed. You also can escape taxes on either the money you put into the IRA or on the money you withdraw in retirement, depending upon if you have a traditional or Roth IRA.

The government limits the amount of money you can put into an IRA each year. Most people under 50 can contribute no more than $5,500 a year (2013).

You can contribute funds to an IRA at any time throughout the year. Additionally, for tax purposes, after the end of the year you can still make contributions towards the previous year's IRA, as long as the contribution is made by the April 15th tax deadline.

Unlike 401(k)s, which are accounts provided by employers, the most common types of IRAs are accounts that you open on your own. You have the choice between Traditional IRAs and Roth IRAs. 

Traditional Individual Retirement Accounts
With a Traditional IRA, you get a tax deduction for the money you put in the account. This deduction reduces your taxable income, so you are not paying tax on the income you put in your IRA. Your contributions grow tax-deferred, which means you don't include interest, dividends, or capital gains from the IRA in your annual income.

When you withdraw the money, the distribution is included in your taxable income. It is taxed as ordinary income. If you withdraw the money before reaching age 59 and a half, there is an additional tax on that early distribution.

Roth Individual Retirement Accounts 
With Roth IRAs, you do pay taxes before you put contributions in your IRA. However, you do not pay taxes when you take distributions in retirement. Your money does grow inside of the IRA without needing to pay any taxes on the earnings and growth.

Which Type is Better for Young Adults?
For young people, generally Roth IRAs are better. Paying taxes on your contributions now is better than getting a tax break today. Most people can expect to be in the same or higher tax bracket when you withdraw the money - usually the case if you contribute when you're young and in a lower tax bracket. Thus, pay less tax now versus more tax later. 

Where Can You Open an IRA? 

You can open an IRA with almost any large financial institution, including banks, credit unions, and mutual fund companies. Most IRA providers offer a variety of investment options, ranging from money market funds to mutual funds to individual stocks, so you can put together a diversified collection of investments within your IRA.

The major difference between most institutions is the fee structure. Make sure to carefully compare fees before choosing where to open your IRA. A no-load (no commission or sales charge) mutual fund family such as Fidelity, T. Rowe Price or Vanguard can be a option.