3. Early Withdrawals
I strongly advise against withdrawing money from your IRAs before retirement.
But if you need money urgently for an emergency, it is easier to take it from a Roth IRA. You cannot withdraw your gains but can withdraw the contributions you made without having to pay taxes or a penalty on them. I see this as a major advantage if I run into a serious emergency at some point.
If you dip into your Traditional IRA account before retirement, you’ll have to pay taxes on it in addition to a 10% penalty for withdrawing early.
There are some exceptions to this rule. You can avoid the 10% penalty if you are withdrawing:
- To fund higher education
- Purchase a house (up to $10,000)
- Pay medical bills that are more than 7.5% of your annual income
- Pay your insurance premium if you are unemployed
- Sustain yourself in case of a permanent disability
4. Income Limits
A Traditional IRA technically has no income limitations and you can contribute to it no matter what your income is. But you can only contribute pre-tax dollars if your income is less than $64,000 (single filing) or $103,000 (married filing jointly). The amount of deduction you can claim reduces gradually if your income goes higher.
A Roth IRA has income limitations. As of 2020, if you have an annual income above $139,000 (single filing) or $206,000 (married filing jointly), you cannot make contributions to a Roth IRA.
However, there is a backdoor entry that is approved by the IRS, by which you can contribute to a Roth IRA irrespective of your income.
All you have to do is put money in a Traditional IRA, convert that account into a Roth IRA, pay the required taxes, and then enjoy the tax-free gains in your Roth IRA. And if the Traditional IRA is empty, you skip taxes entirely which allows you to avoid the limits for an Roth IRA.
What Type of IRA is Right For You?
The biggest factor to consider while choosing the type of IRA is how your money is taxed. There’s a lot of debate in the financial world about which IRA offers better tax savings. I strongly recommend you to go for a Roth IRA.
With a Traditional IRA, the distributions post-retirement are taxed according to your tax bracket at that point. If tax rates fall in the future, then your tax liability may reduce.
But it’s hard to predict which way taxes will go. If your career goes well, then it’s very likely that you will be in a higher tax bracket closer to retirement, increasing the tax on the distributions.
On the other hand, the distributions from a Roth IRA are tax-free.
If you bought stocks of Southwest Airlines worth $10,000 in 1970, they would have been worth about $10 million today. These gains would have been tax-free if you had bought them through a Roth IRA if it had been around then. You would have only had to pay tax on your initial investment of $10,000. How good is that?
If the same investment had been made through a traditional IRA, you would have had to pay tax on each distribution of the $10 million, significantly slowing the amount you could withdraw without getting a hefty tax bill.
As you have a longer investment horizon while investing for retirement, you will be better off to make your gains tax free (as they would go up significantly more than the money you have invested) than your contributions.
The only disadvantage of a Roth IRA is that you don’t get an upfront tax deduction. But there’s a way around it. Many people don’t know, but if you contribute to a Roth IRA and have a low to moderate income, you could be eligible for Saver’s Tax Credit and save on $2,000 in taxes every year.
The Best IRA Accounts
An ideal IRA account has low costs, allows automating investments, and has helpful features like 24×7 customer care and excellent fiduciary choices.
Keeping such factors in mind, here are the best 5 IRA accounts you can start:
1. Vanguard
We love Vanguard. They are the pioneers of low-cost investing. Their reputation is stellar as they are the largest brokerage in the world. They offer a large number of funds that you can choose from. But they are all Vanguard funds, so if you want to invest anywhere else, you should look at other names on this list.
- Some funds need a minimum investment of $3,000 to start off
- No account opening minimums
- Low-cost index funds
- Automatic investing
2. Fidelity
Commission-free trades make Fidelity an amazing place to hold your IRA account. Their trading platform is intuitive with many useful tools. Fidelity is amongst the lowest cost brokers if you are investing on your own.
They offer both Fidelity and non-Fidelity funds, making it unique and more diverse. Fidelity also has lots of helpful educational stuff on its website that will add to your financial knowledge.
- Offer some expense-free index funds
- No account opening minimums
- 10,000 no transaction fee mutual funds
- $4.95 trading fee for the rest of the mutual funds
- Excellent 24×7 customer care
- Automatic investing
3. Charles Schwab
Charles Schwab is an excellent all-round brokerage. They particularly stand out because of their superb team of fiduciaries.
- No account opening minimums
- Helpful 24×7 assistance
- No transaction fee for Schwab funds
- $4.95 trading fee for non-Schwab funds
- Automatic investing
- No maintenance fees
- Option to have banking and investments under one roof
4. Betterment
Betterment works like a robo-advisor. It is perfect for someone who prefers a hands-off approach to investing. You only have to let them know about your risk tolerance, and if you want, your desired asset allocation between stocks and bonds. Betterment will do everything from selecting where to invest and rebalancing the portfolio.
For these services, you’ll be charged a 0.25% management fee apart from the fund’s expense ratio.
- No account opening minimums
- Risk-tolerance based investing
- Automatic portfolio rebalancing
- Automatic investing
5. Ally Invest
Ally is an online-only bank. As it doesn’t have to pay for stuff like property, rent, and employees that is associated with physical banks, Ally can afford to give great rates to its customers. It also has a robo-advising tool.
- No account opening minimums
- No maintenance fees
- 24×7 customer service
- Automatic investing
- Digital only
- Low costs
Learn more about investing money
