If you’re an employee or business owner, have you thought about your retirement? For many Americans entering the workforce, retirement seems like a distant fantasy. Most people that start their career have a good 45-years to make their fortune before they head off into the sunset and enjoy their senior years.
However, for many Americans, retirement isn’t an option. The rising cost of living and stagnant wage growth across all sectors means that some people will never be able to stop working. This market is not the baby boomer economy of the seventies, eighties, and nineties.
Since the Great Financial Crisis of 2008, the global economy found itself struggling to recover from the effects of inflated asset bubbles that popped, leaving markets across the globe in dire straits. Many people lost everything they owned in this crisis, with very few people prepared for the financial onslaught that followed.
Preparation is critical for survival, and we aren’t talking about stocking up on canned supplies and water. Preparing for an economic slump, and the impact it has on your finances is critical if you want to spend your retirement years in a comfortable financial position.
Saving for Retirement – The Problem with Banks
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Since the onset of the Dotcom bust in 1999, the then Federal Reserve Chair, Alan Greenspan, started an easing cycle where the Fed cut rates to zero. This monetary policy move made it easy for financial institutions to borrow money, without the need to pay any interest on the funds.
While this strategy was a boon for markets and investors, it didn’t help the average Joe who allocated their funds to their savings account with the bank. Suddenly, the average saver went from receiving 5-percent on their money in their savings account to earning noting. Most savers started losing money, due to the banks chewing up their cash with monthly and annual fees.
Today, the situation is not much better. The Federal Reserve diverged from its easing policy in late 2015, starting the next tightening cycle by raising interest rates. Unfortunately, some 4-years later, and the Fed has only managed to lift rates to 2.5-percent. Unfortunately, the banks did not follow suit, and now no bank offers you any interest on money parked in a savings or checking account.
Read: What is an IRA? Complete Guide to Individual Retirement Accounts
Market Cycles and the Economy
While savings with banks quickly became a moot point for the average American, some people managed to make their retirement savings grow elsewhere. With the launch of easing policy by the Fed in 2000, financial institutions had the opportunity to invest in markets using money without the need to pay any interest on it.
This era of free money sent the stock market to the moon, particularly the S&P 500, which achieved all-time highs of 1,576 on October 2007, before the onset of the Great Financial Crisis of 2008, sparked by the insolvency of Lehman Brothers. After the crash, the market sank to 666, before the Fed intervened with the start of QE, or “Quantitative Easing,” which saw financial institutions pump billions of dollars into the markets.
This intervention sparked the next boom cycle in the economy to recover from the effects of the crash. Today, the S&P500 sits at all-time highs above the 3,000 mark, even during a hiking cycle where the Federal Funds Rate moved up to 2.5-percent.
Saving for Retirement – How Savvy Investors Made Money
After 2000, the moves in the market were breathtaking to watch. During this period, many investors made millions of dollars by investing in the stock indices as they rose to the moon.
So, how does this benefit the average American, and how does it help them save for retirement?
Investment companies offer a product called Individual Retirement Accounts. These accounts are either self-managed or managed by professional account managers at top financial firms. An IRA allows the average American to take their retirement savings, and add them to this vehicle. After contributing to the fund, your money goes into an investment pool managed by a professional investment manager.
The manager allocates the funds into a diverse range of assets, based on your risk tolerance. Assets like index funds, ETFs, mutual and property funds, stocks, and bonds – are all in play.
You benefit from the buying power of the money under control of the investment manager, which may, in some cases, be billions of dollars. As the markets move upward, so does your investment, allowing you to benefit from the price action.
IRAs are fast becoming one of the most popular retirement savings vehicles available. Depending on your investment strategy, you could see significant returns on your money that supersede anything you could expect from a savings account, even if you were saving in the nineties.
Read Also: WealthSimple Review
The Individual Retirement Account – IRA
By now, you should have a firm understanding of why it’s crucial to invest in your retirement, and how an IRA can help you achieve your financial goals for your senior years.
When setting up an IRA, there’s plenty that you need to understand before you commit yourself to open an IRA. Let’s take a look at the types of IRAs available and the differences between each of them.
The Traditional IRA
When it comes time to open your IRS, you have two options, the traditional IRA, or the “Roth” IRA.
When you open a traditional IRA, you subtract the amount you invest in the fund from your taxable income for the year. As a result of your contributions, the IRS takes the position that your earned income shrinks by the amount you contribute to the investment.
The IRS does not require you to pay any taxes on your contributions, but they collect when you cash out the fund during your retirement. Let’s take an example where you earn $50,000 per year in income. Under normal circ*mstances, the 2019 tax table states that you would have to pay 11-percent of your income to the IRS during tax season. Therefore, you owe the IRS $11,000 to cover your income tax.
However, if you invest $5,000 into your IRA during the year, then your taxable income drops to $45,000. As a result of your change in earnings, you save $1,100 on your tax bill, and you only need to pay the IRS $9,900.
Anyone under the age of 70.5-years old, and earns an income, is eligible to open a traditional IRA. A traditional IRA is beneficial to those individuals who are over the age of 40, as they have fewer working years left in their career.
As, a result, these individuals may be in a higher tax bracket. Therefore, if you are in a higher tax bracket toward the end of your career, the tax savings can benefit your financial position, as you’ll only need to pay the tax on your investment when you cash it out at your retirement.
This strategy means that you’ll benefit from paying less tax if you are in a higher income bracket than you would if you selected a Roth IRA (more about that in a minute). People that work as freelancers can also benefit from the tax strategy associated with a traditional IRA.
Since most freelancers work from contract to contract, they may end up in trouble at tax season if they don’t have the funds available to pay their taxes. By using a traditional IRA, you get to diminish your taxable income, allowing you to better manage your cash flow during the year and at tax season.
The Roth IRA
Established by Senator William Roth of Delaware, the Taxpayer Relief Act of 1997 (Public Law 105-34), facilitates the legislature surrounding the Roth IRA. The senator pioneered the legislation to help more young Americans save toward their retirement.
The primary difference between the traditional IRA and the Roth IRA is in the taxation on contributions and settlement amounts. As mentioned, you make your contributions to the traditional IRA facility using pre-tax dollars. After cashing out your retirement fund, you settle your outstanding tax bill with the IRS.
However, with the Roth IRA, you pay taxes on your earned income, regardless of your contributions to your investment. Therefore, you are paying tax on your contributions to the Roth IRA. However, when it comes time to cash out your investment, you don’t owe the IRS any of the money, and it’s all you to keep and use as you please.
Therefore, the Roth IRA suits younger people who are starting in the workforce. When starting your career, then chances are you are making far less than at the end. Therefore, you are paying less tax because you are in a lower tax bracket. When you cash out at the end of your investment term, you don’t have to worry about being in a higher tax bracket.
Both types of IRA are long-term investment vehicles. If you cash out your traditional IRA early, you can expect to pay a 10-percent taxation penalty. With a Roth IRA, you can withdraw your contributions at any time, but you’ll have to pay any taxes on earnings, as per a sliding scale set by the IRS.
The Contribution Limits to Your IRA
Both the traditional IRA and Roth IRA have limitations on annual contributions to the fund. For the 2019 tax year, the limit for both types of IRAs is $7,500 for people aged 50 and over, and $6,500 for people under the age of 50-years old.
Married couples that file jointly can double that figure if they are putting it in a single account. Even if your spouse is unemployed, you can still access the double contribution, thanks to the Kay Bailey Hutchison Spousal IRA Limit. This limit permits married couples to contribute jointly.
Institutions Offering You an IRA
So, where do you open an IRA account? There are a variety of financial institutions that allow you to sign up for a traditional or Roth IRA online. Banks, investment firms, brokerages, and even tax professionals offer IRA accounts to their clients.
However, when selecting your preferred provider, there are a few tips to consider before you sign on the dotted line and start making contributions.
Tips for Selecting Your IRA Provider
When choosing the financial institution to open your IRA, you must consider two important factors that will affect the growth and management of your investment.
The first factor is the institution. Various institutions offer an IRA service. However, not all institutions offer the same returns on your money. As mentioned, an IRA allows you to pool your funds with other investors in an account managed by the institution. All the finds are segregated to prevent confusion and misallocation, but you benefit from the combined buying power of the entire fund.
This strategy allows professional money managers to diversify the assets in your IRA to avoid risk. Premier financial institutions, like investment banks, have talented money managers that make their career out of successful investing. Therefore, you get to benefit from the fund manager’s investment knowledge and optimize the growth of your IRA account.
However, you need to pay attention to the costs involved with managing your investment. Many of the top banks charge higher fees than other institutions because they know you are willing to pay more for senior money managers to oversee your finances. Before you commit to an IRA, always enquire about fees and costs involved with the management of your investment.
If you are a day trader or have investment knowledge, then you can open an account with a brokerage firm, and manage your investment yourself. Day trading stocks, futures, and index funds can help you achieve an exponential growth in your money that far exceeds anything that fund managers can do with your funds. However, there is high-risk involved in day trading, and if you lose all of the money in your fund, you will still be liable for the taxes and charges on your capital.
Wrapping Up – Key Takeaways
With the current state of wages and the economy, it’s a prudent strategy to start saving for your retirement as soon as possible. An IRA can help you reach your retirement goals while minimizing your tax responsibility to the IRS.
There are two types of IRAs available, the traditional and the Roth IRA. Speak to an investment advisor to understand which model suits your current financial status and your age. An IRA is a long term investment, and you should never consider cashing out early unless you want to get stuck with penalties, taxes, and fees.
However, if your IRA reaches maturity, you can expect to enjoy your retirement, without any financial concerns that you will run out of money before you run out of time.
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