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Financial Planner, Betterment
Andrew Westlin is a financial planning professional at Betterment, where he provides personalized advice to customers. Passionate about financial planning and analysis, Andrew answers customer questions every day over the phone or via Betterment's mobile app.
Articles by Andrew Westlin
What’s an IRA and How Does It Work?
Learn more about this investment account with tax advantages that help you prepare for ...What’s an IRA and How Does It Work? Learn more about this investment account with tax advantages that help you prepare for retirement. An Individual Retirement Account (IRA) is a type of investment account with tax advantages that helps you prepare for retirement. Depending on the type of IRA you invest in, you can make tax-free withdrawals when you retire, earn tax-free interest, or put off paying taxes until retirement. The sooner you start investing in an IRA, the more time you have to accrue interest before you reach retirement age. But an IRA isn’t the only kind of investment account for retirement planning. And there are multiple types of IRAs available. If you’re planning for retirement, it’s important to understand your options and learn how to maximize your tax benefits. If your employer offers a 401(k), it may be a better option than investing in an IRA. While anyone can open an IRA, employers typically match a portion of your contribution to a 401(k) account, helping your investment grow faster. In this article, we’ll walk you through: What makes an IRA different from a 401(k) The types of IRAs How to choose between a Roth IRA and a Traditional IRA Timing your IRA contributions IRA recharacterizations Roth IRA conversions Let’s start by looking at what makes an Individual Retirement Account different from a 401(k). How is an IRA different from a 401(k)? When it comes to retirement planning, the two most common investment accounts people talk about are IRAs and 401(k)s. 401(k)s offer similar tax advantages to IRAs, but not everyone has this option. Anyone can start an IRA, but a 401(k) is what’s known as an employer-sponsored retirement plan. It’s only available through an employer. Other differences between these two types of accounts are that: Employers often match a percentage of your contributions to a 401(k) 401(k) contributions come right out of your paycheck 401(k) contribution limits are significantly higher If your employer matches contributions to a 401(k), they’re basically giving you free money you wouldn’t otherwise receive. It’s typically wise to take advantage of this match before looking to an IRA. With an Individual Retirement Account, you determine exactly when and how to make contributions. You can put money into an IRA at any time over the course of the year, whereas a 401(k) almost always has to come from your paycheck. Note that annual IRA contributions can be made up until that year’s tax filing deadline, whereas the contribution deadline for 401(k)s is at the end of each calendar year. Learning how to time your IRA contributions can significantly increase your earnings over time. Every year, you’re only allowed to put a fixed amount of money into a retirement account, and the exact amount often changes year-to-year. For an IRA, the contribution limit for 2022 is $6,000 if you’re under 50, or $7,000 if you’re 50 or older. For a 401(k), the contribution limit for 2022 is $20,500 if you’re under 50, or $27,000. These contribution limits are separate, so it’s not uncommon for investors to have both a 401(k) and an IRA. What are the types of IRAs? The challenge for most people looking into IRAs is understanding which kind of IRA is most advantageous for them. For many, this boils down to Roth and/or Traditional. The advantages of each can shift over time as tax laws and your income level changes, so this is a common periodic question for even advanced investors. As a side note, there are other IRA options suited for the self-employed or small business owner, such as the SEP IRA, but we won’t go into those here. As mentioned in the section above, IRA contributions are not made directly from your paycheck. That means that the money you are contributing to an IRA has already been taxed. When you contribute to a Traditional IRA, your contribution may be tax-deductible. Whether you are eligible to take a full, partial, or any deduction at all depends on if you or your spouse is covered by an employer retirement plan (i.e. a 401(k)) and your income level (more on these limitations later). Once funds are in your Traditional IRA, you will not pay any income taxes on investment earnings until you begin to withdraw from the account. This means that you benefit from “tax-deferred” growth. If you were able to deduct your contributions, you will pay income tax on the contributions as well as earnings at the time of withdrawal. If you were not eligible to take a deduction on your contributions, then you generally will only pay taxes on the earnings at the time of withdrawal. This is done on a “pro-rata” basis. Comparatively, contributions to a Roth IRA are not tax deductible. When it comes time to withdraw from your Roth IRA, your withdrawals will generally be tax free—even the interest you’ve accumulated. How to choose between a Roth IRA and a Traditional IRA For most people, choosing an Individual Retirement Account is a matter of deciding between a Roth IRA and a Traditional IRA. Neither option is inherently better: it depends on your income and your tax bracket now and in retirement. Your income determines whether you can contribute to a Roth IRA, and also whether you are eligible to deduct contributions made to a Traditional IRA. However, the IRS doesn’t use your gross income; they look at your modified adjusted gross income, which can be different from taxable income. With Roth IRAs, your ability to contribute is phased out when your modified adjusted gross income (MAGI) reaches a certain level. If you’re eligible for both types of IRAs, the choice often comes down to what tax bracket you’re in now, and what tax bracket you think you’ll be in when you retire. If you think you’ll be in a lower tax bracket when you retire, postponing taxes with a Traditional IRA will likely result in you keeping more of your money. If you expect to be in a higher tax bracket when you retire, using a Roth IRA to pay taxes now may be the better choice. The best type of account for you may change over time, but making a choice now doesn’t lock you into one option forever. So as you start retirement planning, focus on where you are now and where you’d like to be then. It’s healthy to re-evaluate your position periodically, especially when you go through major financial transitions such as getting a new job, losing a job, receiving a promotion, or creating an additional revenue stream. Timing IRA contributions: why earlier is better Regardless of which type of IRA you select, it helps to understand how the timing of your contributions impacts your investment returns. It’s your choice to either make a maximum contribution early in the year, contribute over time, or wait until the deadline. By timing your contribution to be as early as possible, you can maximize your time in the market, which could help you gain more returns over time. Consider the difference between making a maximum contribution on January 1 and making it on December 1 each year. Then suppose, hypothetically, that your annual growth rate is 10%. Here’s what the difference could look like between an IRA with early contributions and an IRA with late contributions: This figure represents the scenarios mentioned above.‘Deposit Early’ indicates depositing $6,000 on January 1 of each calendar year, whereas ‘Deposit Late’ indicates depositing $6,000 on December 1 of the same calendar year, both every year for a ten-year period. Calculations assume a hypothetical growth rate of 10% annually. The hypothetical growth rate is not based on, and should not be interpreted to reflect, any Betterment portfolio, or any other investment or portfolio, and is purely an arbitrary number. Further, the results are solely based on the calculations mentioned in the preceding sentences. These figures do not take into account any dividend reinvestment, taxes, market changes, or any fees charged. The illustration does not reflect the chance for loss or gain, and actual returns can vary from those above. What’s an IRA recharacterization? You might contribute to an IRA before you have started filing your taxes and may not know exactly what your Modified Adjusted Gross Income will be for that year. Therefore, you may not know whether you will be eligible to contribute to a Roth IRA, or if you will be able to deduct your contributions to a Traditional IRA. In some cases, the IRS allows you to reclassify your IRA contributions. A recharacterization changes your contributions (plus the gains or minus the losses attributed to them) from a Traditional IRA to a Roth IRA, or, from a Roth IRA to a Traditional IRA. It’s most common to recharacterize a Roth IRA to a Traditional IRA. Generally, there are no taxes associated with a recharacterization if the amount you recharacterize includes gains or excludes dollars lost. Here are three instances where a recharacterization may be right for you: If you made a Roth contribution during the year but discovered later that your income was high enough to reduce the amount you were allowed to contribute—or prohibit you from contributing at all. If you contributed to a Traditional IRA because you thought your income would be above the allowed limits for a Roth IRA contribution, but your income ended up lower than you’d expected. If you contributed to a Roth IRA, but while preparing your tax return, you realize that you’d benefit more from the immediate tax deduction a Traditional IRA contribution would potentially provide. Additionally, we have listed a few methods that can be used to correct an over-contribution to an IRA in this FAQ resource. You cannot recharacterize an amount that’s more than your allowable maximum annual contribution. You have until each year’s tax filing deadline to recharacterize—unless you file for an extension or you file an amended tax return. What’s a Roth conversion? A Roth conversion is a one-way street. It’s a potentially taxable event where funds are transferred from a Traditional IRA to a Roth IRA. There is no such thing as a Roth to Traditional conversion. It is different from a recharacterization because you are not changing the type of IRA that you contributed to for that particular year. There is no cap on the amount that’s eligible to be converted, so the sky’s the limit for those that choose to convert. We go into Roth conversions in more detail in our Help Center.
5 Financial Steps To Take After Getting A Raise
When you get a raise at work, consider how you can maximize your earnings to identify new ...5 Financial Steps To Take After Getting A Raise When you get a raise at work, consider how you can maximize your earnings to identify new financial opportunities. If you’ve recently received a raise, congratulations! You worked many long hours to deserve this, and now your hard work has paid off. Whether this pay increase was expected or whether it was a complete surprise, you may have many thoughts running through your mind, including calling your spouse or your Mom, deciding what restaurant you are dining at for a celebration, or how your new salary will give you more freedom to take that vacation you’ve been wanting to go on. While you should be excited, it’s important to take a step back to reassess your new pay and how it impacts your financial situation. Without doing so, you might find that your raise is more harmful than when you were making less money. To avoid having “raise regret”, consider these five tips. 5 Things To Do After Receiving A Raise 1. Understand your new salary. While you deserve to celebrate, you may want to hold off on making any large purchases that were unplanned and not saved for with your new cash flow. Unlike a bonus, where you receive a lump sum, your raise is going to be broken out across all pay periods. Additionally, your raise is going to be stated as an increase to your gross pay. In other words, if you receive a $5,000 annual raise, that does not mean that you are pocketing $5,000 over the course of the next year because we have to pay taxes. If you aren’t familiar with the amount of taxes you pay, it could be worthwhile to check your last few pay stubs to determine how much was going to taxes versus how much you were keeping. Also note that depending on the amount of your raise and the time of year, it may push you into a higher tax bracket. You may want to speak with your Human Resources and Payroll departments to discuss your tax withholding, as well as an accountant or qualified tax professional to see how your increased earnings could impact your personal tax situation. 2. Increase your retirement savings. If your employer offers a 401(k) plan and matches your contributions, you should consider contributing at least enough to get the full match amount. Even if you were already doing so, or your employer doesn't offer a match, increasing your retirement savings may still be a great option to consider. And, for those who are comfortable with their lifestyle prior to receiving a raise and don’t plan to make any changes, you can supercharge your savings rate at an equivalent rate. Determining how much you need to save for retirement will depend on several factors. Betterment offers retirement planning tools that can provide guidance on not only how much you should save, but the optimal accounts for you to do so based on your information. 3. Establish, or revisit, your emergency fund. Having an emergency fund is a very important financial savings goal, as it can help ensure a level of financial security for yourself and your family. An adequate emergency fund can help you cover truly large and unexpected expenses, and can also help cover your costs if you end up losing your job. It can even provide financial freedom in the case that you want to try your hand at a new career. Typically, Betterment advises that your emergency fund should cover three to six months’ worth of expenses. If you didn’t have one prior to your raise, now would be a great time to start. If you already have an emergency fund, you may need to reevaluate the amount needed if your spending does increase. 4. Pay off debt. If you have any debt, especially high interest debt, you may choose to use this new capital to pay off some of your loans quicker. You’d not only have the potential to shave years off the repayment process but save thousands of dollars in interest. Here’s a hypothetical to demonstrate. Let’s assume that you’re a single taxpayer, live in a state with no state income tax, and at the start of 2022 your pay went from $60,000 to $65,000. Assuming you don’t itemize, that would place you squarely in the 22% Federal tax bracket. If you get paid twice per month (24 times per year), your net paycheck would go from $1,950 to $2,112, an increase of $162. Now let’s say you put that extra cash to work on your hypothetical student loans, which total $50,000 at 7% interest paid over 10 years. Increasing your monthly loan payment by that $162 would allow you to pay off your loans almost three years faster, and also help you save almost $6,000 in interest payments! 5. Invest in yourself. Okay, let’s say you’re already on track with your retirement goals, have an emergency fund, and paid off your debt. What do you do then? Investing in yourself can have immense value. And the best part is, it can be done in many ways. Whether that’s taking a vacation to reset your mind after months of diligent work, taking a class to enhance your skills or learn a new one, or even making a material purchase that you feel will better your quality of life, investing in yourself can be a great way to reap the benefits of your hard earned work. If you plan on spending this extra money, just make sure that it’s within your means—don’t fall victim to lifestyle creep. Inherently, you may be a saver by nature. While it’s important to set goals, you may not have a specific goal for these additional savings—and that’s ok. By investing additional cash flow in a well-diversified portfolio, you give that money a chance to grow and be put to good use at some point down the line. Using a taxable investment account for a general investing goal, for example, will give you more flexibility relative to retirement investment accounts as to how and when these savings can be used.