Should you put your money in a Roth or traditional retirement account in 2022?
Here’s how to make the right call.
- It’s a good idea to set aside some of your income for retirement savings.
- There are several accounts you can choose from, and each has its own distinct tax benefits.
As a general rule, it’s a good idea to set aside a substantial portion of your salary for retirement savings. You will need this money in the future to cover your bills once you stop working, because even though Social Security will provide some income is usually not enough to live comfortably.
Now, when it comes to choosing a retirement plan, the choice is yours. If your company offers a 401(k), it might be beneficial to enroll, especially if there is an employer match (where your company will give you free money to contribute funds from your own paycheque). But if you don’t have access to a 401(k), you can open an IRA.
IRAs come in two varieties – traditional and Roth. And each has its own pros and cons from a tax standpoint. If you’re not sure which retirement account is best for you this year, here’s how to make that decision.
Advantages and Disadvantages of the Traditional IRA
With a traditional IRA, the money you contribute is paid out before taxes. If you’re under 50, you can contribute up to $6,000 this year, or up to $7,000 if you’re 50 or older. (Note that this tax relief may not apply to you depending on your income and whether you also participate in a 401(k) plan).
Once you fund a traditional IRA, your money grows tax-deferred. This means that when you benefit from winnings in your account, you do not pay tax on them year after year. Instead, you only pay taxes when you make withdrawals from your account later. This money is yours to enjoy without penalty once you reach age 59.5.
If you’re worried about a big tax bill this year, a traditional IRA might make sense. Let’s say you are 40 years old and contribute the maximum amount for your age. That means the IRS won’t be able to tax $6,000 of your salary, which could be a big savings.
Advantages and disadvantages of Roth IRA
Roth IRAs have the same annual contribution limits as traditional ones. With a Roth IRA, there is no tax relief on the money that goes into your account. You also may not be able to directly fund a Roth IRA if you have a higher income, although you can usually get around this by contributing to a traditional IRA and then converting it to a Roth afterwards.
The benefit of putting money into a Roth IRA, however, is that any earnings you enjoy in your account are tax-free. Withdrawals are also tax-free, giving you more financial flexibility during retirement when money might be tight.
Additionally, you are supposed to wait until age 59.5 to access your Roth IRA funds to avoid penalties on early withdrawals. But technically, you can withdraw some of your major contributions before that age and avoid penalties, because that money never had the favorable tax treatment to begin with. It is only once you withdraw your winnings early that penalties kick in with a Roth. In other words, if you contribute $6,000 to your Roth IRA this year and it reaches $6,500, you’ll avoid penalties as long as you leave your $500 of earnings alone until age 59½.
Now let’s say you start 2022 with no emergency savings. Putting your money in a Roth IRA might make sense, because while the purpose of the account is to set aside funds for retirement, it also doesn’t hurt to know that you can, if needed, tap into your IRA without penalty in a pinch.
What’s the right call?
If you don’t expect a huge tax bill this year and think you’ll be in a higher tax bracket later in life than you are now (for example, because you don’t don’t have a very high income), then a Roth IRA might make sense this year. But if you’re worried about taxes, a traditional IRA may be a better bet.
The great thing about IRAs is that you don’t have to make a lifetime commitment. You can start with one type of IRA this year and fund another next year if your circumstances change. You can even split your retirement contributions between a traditional IRA and a Roth this year if that’s the route you decide to take.
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