I’m not a fan of paying taxes. I’ll of course follow the rules and do it because I have to, but I’d rather do everything I can to pay the IRS as little as possible — within legal limits, of course.
That’s why I’m a big fan of saving for retirement in an individual retirement account (IRA). Each year, the IRS sets a contribution limit for IRAs. The current limit is $7,000 if you’re under age 50 or $8,000 if you’re 50 or older, but these numbers could change in 2025.
The benefits of IRAs
The more money you put into a traditional IRA up to the limit that applies to you, the more income you can shield from taxes. For example, if you fall into the 22% tax bracket and you contribute $7,000 to an IRA, you’ll save yourself $1,540.
Plus, investment gains in an IRA are tax-deferred. You don’t pay taxes on them each year like you would in a regular brokerage account. Rather, you’re taxed at the time you take withdrawals.
This beats a brokerage account because let’s say you sell stocks at a gain in one of these accounts but reinvest the money instead of withdrawing it to spend. Well, you still need to pay capital gains taxes that year. But with an IRA, you’re only being taxed when you take withdrawals.
As much as I would recommend maxing out an IRA for the tax benefits, I don’t recommend putting all of your retirement savings into one. Doing so could come back to bite you if you end up wanting to retire early.
The problem with IRAs
The IRS offers some nice tax benefits for IRA participants. But in exchange, the IRS wants to make sure that money is earmarked for retirement — not something else. Generally speaking, you’ll face a 10% early withdrawal penalty if you remove money from your IRA before turning 59 1/2.
There are some limited exceptions to this rule, such as paying for college. And you can take up to a $10,000 withdrawal penalty-free to purchase a home for the first time.
But otherwise, you risk being penalized for accessing money that’s yours. And that kind of stinks. But for this reason, it’s a good idea to keep some of your retirement savings outside of an IRA.
If you want that money invested, a brokerage account is a good bet. You can even use a regular old savings account (though it’s best to invest the majority of your long-term savings so that money is able to grow). But it’s important to have at least one account earmarked for retirement that isn’t restricted by the IRS. That way, if you decide you’ve saved enough to retire by age 48 or 54 or 57, you don’t have to face a penalty for accessing funds to live on.
Remember, too, that even if you don’t actively choose to retire early, you may be forced to do so. Your health could decline and leave you unable to work. Your company could fold, leaving you to struggle to find a suitable job as a replacement source of income.
There are, unfortunately, a lot of ways your retirement plans might get upended. You need the flexibility to access at least some of your savings whenever you might need to.
A Roth IRA solves the problem, but you lose the upfront tax break
If you’re looking for a second home for your money outside of a traditional IRA, you could look at putting some of your savings into a Roth IRA. With a Roth IRA, you won’t get an upfront tax break on your contributions, but your investment gains will be tax-free. And the same applies to your withdrawals.
Also, because you don’t get a tax break on the money you contribute to a Roth IRA, you’re not penalized for early withdrawals as long as you only touch the contribution portion of your account, not the gains portion. So if you contribute $15,000 to a Roth IRA and your balance grows to $60,000 through the years, you can withdraw the $15,000 whenever you want without penalty.
For this and other reasons, splitting your long-term savings between a traditional and Roth IRA could be a smart idea. This gives you the benefit of an up-front tax break on some of your contributions, but also some tax-free income later in life. And you get the ability to access some of your money without stress if you retire ahead of schedule.
