Millennials have faced two financial crises before the age of 40, leaving many wondering, how will I save for retirement?
If millennials want to retire by the age of 65, they need to save nearly half of their paycheck. Others say to retire comfortably you should be saving around 75% of your pre-retirement income. However, 50% of millennials believe all they need is $300,000 to retire in comfort—a small fraction of what most experts estimate they need.
So, how do you achieve that in today’s challenging economic environment? For most, income and contributing to a 401(k) alone won’t cut it.
What other options do you have?
The short answer is, savings and growth from investments and passive income—which we’ll touch on shortly. For now, the main focus is on where you put that investment money, and an IRA is a viable option.
What Is an IRA?
IRA stands for Individual Retirement Account. This option is essentially a savings account that offers significant tax savings. Contributions may be tax-deductible and withdrawals are tax-free.
An IRA is not an investment in itself. This idea is a common misconception. Instead, think of an IRA as the basket that holds bonds, mutual funds, stocks and other assets.
There are different types of IRAs and for millennials, a Roth IRA is a beneficial choice, as this option could set you up for success later in life.
The Benefits of an IRA
The primary benefit of an IRA is that you have more investment options. For example, although a 401(k) is a great way to save for retirement, it’s not enough for many. The same is true for pensions. That is why it’s important to know your options and act on them sooner than later. The more you know, the better you can prepare for retirement by saving the most on taxes and choosing the best investment options for you and your investment plan.
When you have an IRA, you gain the power of flexibility. For example, you can use IRA money to purchase your first house or to start investing in the real estate market.
Overall, the main benefits include:
- Having many investment options to choose from, allowing you to diversify.
- Saving money for retirement.
- Cutting your tax bill.
- Access to an IRA, regardless of your situation.
Know that if you choose to have an IRA, you can still have a 401(k) to get the full employer match.
Types of IRAs
“IRA” is not a singular term. There are different types of IRAs, including the following four.
The two that are most known are a traditional IRA or a Roth IRA. The difference is whether you want to pay taxes now or later.
The IRS offers a chart highlighting the primary similarities and differences.
There are rules no matter which IRA you choose, so it’s important to know what you can expect. For starters, IRAs have contribution limits. For 2022, this limit is $6,000 per person who is under age 50. An IRA catch-up contribution limit is available for workers age 50 and older. For 2022, this limit is $1,000. So, a maximum contribution of $7,000 per person for 2022 in total.
Dive deeper into contribution and deduction limits, distributions, rollovers, and more here.
Traditional IRAs
The original IRA is now called a traditional IRA. Created by the 1974 legislation known as the Employee Retirement Income Security Act (ERISA), it was an option for those who did not have access to a tax-advantaged retirement saving option through their employer. In 1997, this type of IRA was later supplemented by the Roth IRA. To this day, the ERISA is arguably one of the most important pieces of retirement legislation in America’s history. It paved the way for both IRAs and 401(k)s.
Contributions to traditional IRAs are typically tax-deductible. For example, if you contribute $6,000 to a traditional IRA, you could reduce your taxable income by $6,000. The catch is, when you withdraw money from traditional IRAs, these withdrawals are taxable as regular income.
This means your contributions will lower your taxable income each year. That money is then invested. However, after age 59½, you will owe taxes on it when you take it out. You’re essentially deferring your tax bill.
From 2014 to 2019, traditional IRA balances increased by 50.1%, from $6.23T to $9.35T. The breakdown of this increase is as follows:
- 49% due to rollovers and employer plans.
- 49% from the market appreciation of investments.
- 2% from annual IRA contributions.
Roth IRAs
Roth IRAs are very different from traditional IRAs in that contributions to a Roth IRA are not tax-deductible and withdrawals are tax-free. There are also no taxes on investment gains. If you’re a young investor with many years until retirement, this may be an ideal option for you because the more time your money has to grow, the larger the long-term benefit of the tax growth on your investments. This option is also often recommended to those in a lower tax bracket.
In this case, you invest money that has already been taxed. Once you hit retirement and withdraw funds, that money will be tax-free, as long as you remain within the withdrawal requirements. Think of this option as pre-paying your taxes so that you don’t need to worry about it when you retire.
Unlike a traditional IRA or a 401(k), this option can also be used as a backup emergency fund because you won’t be hit with an early withdrawal penalty when you take out the contributions.
SEP IRAs
SEP IRAs are often for self-employed individuals and small business owners who have few or no employees. Like traditional IRAs, contributions are tax-deductible.
SIMPLE IRAs
SIMPLE IRAs stand for Savings Incentive Match Plan for Employees Individual Retirement Plans. Again, this is for businesses, but in this case, those with fewer than 100 employees. Contributions are tax-deductible.
How Do IRAs Work?
The main idea behind an IRA is to invest money and allow it to compound. How your balance grows will depend on several variables, including how you invest and how much you contribute.
For young investors, it’s essential to consider your risk tolerance and financial situation. However, if you don’t need your money in, say, the next five years, you should be investing in potentially high-return stocks and assets, in addition to having an IRA. That’s how you outperform inflation.
If you’re wary of investing, then it’s time to do some research, investing in companies and industries that continue to increase in value over time. Yes, the stock market is an attractive option and can certainly be part of your portfolio. However, only around 4% of those playing the stocks actually make decent money, which is why indirect investment is such an attractive option moving forward.
One such industry is real estate because it assures a return on investment.
Real estate has always been on millennials’ list of must-have investments, but that is easier said than done. High prices have prevented most millennials from investing in properties.
Using Your IRA for Real Estate
Traditionally, when you think of IRAs, you think of mutual funds, bonds, ETFs, stocks, and other financial assets—but real estate can also be added to this list.
In this case, the basic fact is, your IRA technically owns the property. It is meant to be purely an investment, which is what you want if you plan to save for retirement. This is an excellent way to diversify your portfolio, especially since real estate appreciates over time and provides a steady income stream.
The downside is that this process can be rather complex and maintenance can be a headache. If you’ve avoided the idea of making money through property investments because the process is too overwhelming, there are real estate investment platforms like Ark7 that can help you get your foot in the door, starting today.
