Do you dream of retiring with enough money to do whatever you want, whenever you want? It’s a great goal, but there’s a catch: Like everything else in life, you’ll need to figure out how to pay for it.
Unless you’re a trust-fund kid, a lottery jackpot winner or a wealthy one-percenter, building a retirement nest egg big enough to fund a post-work life of leisure is pretty much all on you. Sorry to be a buzzkill, but you’ll have to squirrel away—and invest—a big chunk of the money you earn to live comfortably in retirement.
Fidelity Investments, for example, says you should shoot to save up to 15% of your income every year. But shockingly, one in four (25%) non-retired Americans don’t have any money set aside for retirement at all, according to the Federal Reserve. And only 36% of adults say they’re on track to have enough savings for their golden years. So clearly, there’s a lot of work to do.
And statistically, women live longer than men, which means their money needs to last even longer in the late stages of their lives.
If you’re in need of a new financial partner to help you reach your retirement goals outside of an employer-sponsored plan, it’s time to meet your new bestie: the individual retirement account—better known as an IRA.
What Is an IRA?
IRAs are one of the most popular retirement savings vehicles available in the world of finance. The $11.7 trillion invested in IRAs as of the end of June actually surpassed the $6.5 trillion sitting in employer-sponsored 401(k) plans, according to the Investment Company Institute.
One of the key benefits of this retirement savings vehicle is that all of the money you set aside grows tax-free. “And over decades, that tax-deferral benefit can be significant,” says certified financial planner Michelle Spaziani, founder and CEO of Summit Behavioral Wealth.
You can also have an IRA as well as your employer-sponsored plan. So if you’re making enough money where you think you’ll reach your 401(k) contribution limit (which is $20,500 in 2022), an IRA can serve as an additional place to grow your retirement fund (up to its own limit, which we’ll cover below).
Two Types of IRAs
Traditional IRA. This account is funded with pre-tax dollars from your paycheck. And there’s an upside to that beyond saving: It lowers your tax bill in the year you make the contribution because it reduces the dollar amount of your paycheck that is subject to income taxes.
Another plus: Your contributions and any earnings grow tax-deferred (translation: You don’t pay any taxes until you withdraw money.). You will, however, be required to pay ordinary income tax on any withdrawals, which you must start taking after age 72 if you haven’t already. (Note: If you take distributions before age 59½, you’ll be subject to a 10% penalty as well as regular taxes.)
With a traditional IRA, you also have the potential to get a tax deduction—though to be eligible for a full deduction, you or your spouse can’t be covered by an employer-sponsored retirement plan such as a 401(k). And, if you are covered by a plan at work, you’ll only be eligible for a deduction if you don’t exceed certain income limits set by the IRS.
Roth IRA. With a Roth IRA, you fund the account with money that has already been taxed by Uncle Sam. As with a traditional IRA, your deposits and any market gains grow tax-free. But the biggest benefit of a Roth IRA is that you won’t have to pay any taxes on withdrawals in retirement.
How Much Can You Contribute?
For the 2022 tax year, the maximum you can contribute in total to either a traditional IRA or Roth IRA is $6,000. The max increases to $7,000 for people age 50 or older, thanks to a $1,000 catch-up contribution as they near retirement.
How to Invest Your IRA Money
The sooner you start socking money away in retirement accounts the better, experts say. The more time your money has to grow without interference from taxes, and the longer you can benefit from fresh account gains building on prior gains, the larger your account balance is likely be in retirement.
“Contribute as much as possible and start the process as early as you can in your financial life,” Spaziani says.
Furthermore, don’t play it too safe. You likely won’t need to tap your retirement funds for 10, 20 or 30 years, and with such a long-term horizon, it makes financial sense to invest in higher-returning, more volatile assets, such as stocks. “Stocks can be helpful in keeping up with inflation,” Spaziani adds.
Plus, you’ll have plenty of time to ride out any market downturns and recoup your paper losses by benefiting from the market rebounds that eventually occur. Stocks, in particular, have recovered from all sorts of crises, including the internet stock crash in 2000, the 2008–2009 financial crisis and the market plunge in March 2020 during the start of the pandemic.
But don’t put all your eggs in one basket. Your retirement account should be widely diversified, with a mix of stocks, bonds and other assets that reflect your risk tolerance and how many years you are away from retirement. You can boost returns and smooth out risk by investing in low-cost, broadly diversified funds, such as index funds, which track broad stock indexes like the S&P 500.
Adam Shell is a freelance journalist. He’s worked as a financial markets reporter at USA Today and an associate editor at Kiplinger’s Personal Finance magazine.
Millie content is licensed from Dotdash Meredith, publisher of Millie, Real Simple, InStyle, Investopedia, The Balance and more.