The three key pathways to saving for retirement
For many people, saving for retirement takes three forms and includes Social Security, a 401(k) plan, and an Individual Retirement Account (IRA). Social Security is a payroll tax that both employer and employee contribute to. The contribution is set and high-earning employees often hit the maximum contribution limit during the year.
A 401(k) plan, on the other hand, is an employer-offered benefit. It is usually administered by a third party and offers employees some measure of control over how and what they invest in. While employers are not required to match employee contributions, they often do, up to a pre-set limit.
The third form of retirement savings is an IRA. An IRA is a retirement savings plan that is set up at a bank or other financial institution and allows individuals to save for retirement by contributing either pre-tax (Traditional IRA) or post-tax (Roth IRA) income. Depending on the specific IRA, the earnings achieved will either be tax-free (Roth IRA) or tax deferred (Traditional IRA).
This post will take a closer look at IRAs, specifically Traditional IRAs and Roth IRAs. We’ll take a deeper dive into the differences between them and provide you with an idea of how much you should contribute on a monthly or annual basis, depending on which type of IRA you have.
Traditional IRAs
With a Traditional IRA, you can contribute up to the limit set for your age and income. Generally speaking, contribution limits are divided between people 49 and younger, and those 50 and older. The income contributed must be pre-tax and is usually set up through an employer. Because of its pre-tax status, the tax on the contributed income, along with the earnings it generates, is deferred until it’s withdrawn. Contributions can be made either monthly or annually.
Roth IRAs
There are some important differences between Roth IRAs and Traditional IRAs. Perhaps the most significant is that contributions are made with post-tax income, so that later withdrawals are tax-free and penalty-free. Another significant difference is that there are income limits that determine whether or not you can contribute to a Roth IRA. In 2023, the upper income limits to be eligible to make a maximum contribution are:
- $153,000 if you’re single or head-of-household
- $228,000 if you’re married filing jointly
As with the Traditional IRA, contributions can be made monthly. Also, while a Roth IRA can be offered through an employer, they are often set up independently by individuals (often with the help of an accountant).
How much should you contribute to your IRA?
The truth is, there isn’t much difference between Traditional IRAs and Roth IRAs when it comes to how much you should contribute on a monthly or annual basis. In 2023, the maximum you can contribute to either a Traditional IRA or a Roth IRA is $6,000 (49 years old or younger) or $7,000 (50 years old or older).
One thing to consider is that, if you have both a Traditional IRA and a Roth IRA, your combined contributions cannot exceed the overall IRA contribution limit without triggering penalties.
As previously mentioned, there are income restrictions that will determine how much you can contribute to a Roth IRA. The restrictions on Traditional IRAs are different in that they determine how much of your contributions you can deduct from your taxable income.
Beyond the contribution limits, there are other factors that will affect how much you contribute, including your overall retirement objectives, monthly budget requirements and which type of IRA you have. Maxing out your IRA contributions is generally considered a good approach. So, assuming you are eligible to make the maximum contribution to your IRA, you can contribute $500/mo. if you’re 49 years old or younger, or $583/mo. if you’re 50 or older.
Finally, because Roth IRA contributions are limited by income, many people choose to contribute to their IRA only once a year. Many investment experts don’t recommend this method since it doesn’t allow individuals to take advantage of dollar-cost averaging. With dollar-cost averaging, you make regular contributions that don’t take market status into consideration. That means some contributions may hit the market on an upswing, while others may find it on a downward trend. The overall trend, however, tends to be upward in most cases.
Selecting your IRA investments
The investments you choose will depend primarily on three factors, including your:
- Retirement objectives
- Investment horizon (i.e., the number of years you can hold your investments before selling them)
- Risk tolerance level
Many individuals choose a mix of investments with higher earning potential (eg., individual stocks or index funds) with those that earn less but are considered more stable (eg., bond funds) to balance their risk tolerance and their objectives.