When it comes to personal finance, one size does not fit all. Each of us comes to money with our personal stories. Consider how you have developed money habits based on your needs, wants, and advice from family or friends. For example, think of how money was treated by your family when you were growing up. In the way money was treated, do you remember money experiences that you liked or didn’t like? How do you feel about those memories? Are there things you do differently now because of those experiences? Do you want to continue those behaviors into the future? What are you accomplishing with your money now?
When you consider the big picture of money, think of what is close to you now and what is far away. What is closest to you? Your income and your expenses. Think about how much money you are bringing home and how much you are spending. Then, based on how much you are spending, calculate how much of an emergency fund you need (or want) based on your expenses (setting aside amounts for 3 months or 6 months). Consider large purchases like your car or truck, a house, or an education and how much you need to dedicate to those items. Finally, consider your retirement and the variety of retirement accounts available, including a IRAs.
An IRA is an Individual Retirement Arrangement. But don’t let the fancy wording fool you: it’s not a thing you buy but a type of account you open. When talking about saving money, people have asked me, “Should I just buy an IRA?” and it doesn’t work that way. How does it work? Consider the accounts you use for checking or savings. The account has your name on it and you deposit or withdraw money from the account. An IRA may take the form of a brokerage account, an insurance policy, or a bank product (like a savings account or certificates of deposit (CDs)). When you open an IRA account, it is titled a specific way so the custodian (bank or firm) knows that it is governed by special rules, particularly around deposits, withdrawals, and taxation. When you look at your statement and find the address or account titling area, you may find the custodian listed on the top line and your name after the letters FBO. FBO is an acronym and means “For Benefit Of.” Guidance on these rules is available through the IRS. The IRS is specific about how much and what may or may not be contributed to an IRA. For example, certain collectibles (artworks, gems, stamps, etc.) and certain types of securities cannot be held in IRAs.
There are two types of IRAs: traditional, or pre-tax, and Roth, or after-tax. Money contributed into an IRA must be earned and there are limits as to how much may be contributed. Those limits may change annually and you may find updated information on the IRS website, www.irs.gov. Also, you may only contribute the maximum amount to one or across both types of IRAs. For example, if you have earned income, under age 50, and earn a salary below the IRS-defined applicable threshold, you may contribute the maximum amount ($6,500 in 2023) to your traditional IRA or your Roth IRA. What if you want to contribute to each IRA account type? As long as your combined contribution does not exceed $6,500, you may contribute to your traditional IRA and your Roth IRA. (Note: in the scenarios described, you would need to open two separate IRAs, one traditional and one Roth.)
There are noteworthy differences between IRA types. Contributing to a traditional IRA may reduce your taxable income via a tax deduction. When you withdraw money from a traditional IRA, you may pay taxes on the amount withdrawn at your ordinary income tax rate and, if you withdraw before age 59 ½, you may pay a 10% penalty. Contributing to a Roth IRA may not reduce your taxable income. When you withdraw money from a Roth IRA, you may not pay taxes as long as you do not withdraw more than you contribute. For example, if you contribute $6,500 to a Roth IRA and withdraw $500 after 5 years have passed, you may not pay taxes because you are withdrawing from the original contribution of $6,500 and you have met the 5-year requirement. (Note: there is a 5-year minimum holding period applicable to the Roth IRA, not the traditional IRA.) What if the money grows to $6,550 and you’ve not made any additional contributions? If you withdraw the full amount of $6,550 after 5 years, you may pay taxes on the $50 plus, if you withdraw before age 59 ½, you may pay a 10% penalty.
In addition to the basics, there are rules to consider when it comes to IRAs. Consider talking with a tax or financial professional about IRAs and whether it makes sense for you to contribute to a traditional IRA, Roth IRA, neither, or both based on your personal financial goals. Truly, when it comes to personal finance, one size does not fit all. However, knowing the basics about the variety of account types available to help you reach your goals may help you make informed decisions about what may be an ideal fit for your personal situation.
Wendolyn Forbes is a CERTIFIED FINANCIAL PLANNER™ with Wealth Transition Finance, A Member of Advisory Services Network, LLC. Wendolyn is a fee-only financial planner and member of the National Association of Personal Financial Advisors (NAPFA). For more information, please visit her website at www.wtf-asn.com.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and federally registered CFP® (with flame design) in the US, which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
This material is provided as a courtesy and for educational purposes only. Advisory Services Network, LLC does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state laws are complex and constantly changing. Consult your own legal or tax professional for information concerning your individual situation.
Originally published in the August 23, 2023 issue of Rumble by Smoky Mountain News.