WTF is an IRA?

Plan now, retire later. If you haven’t taken a finance course, you probably don’t know much about IRAs. If you have, your professor probably told you that you should open one as soon as you graduate and start your first real job. What is an IRA? IRAs, or individual retirement arrangements, help you fund your retirement when retirement still seems like an eternity away.

When Should I Open an IRA?

The sooner you can open an IRA, the better. Many professionals recommend you start investing in your retirement as soon as you start earning a steady income. The earlier you start saving, the less you will have to set aside each month to fund your retirement.  In both a Roth IRA and a traditional one, your money will grow in your account tax-free. The two types of accounts mainly differ in how you pay income taxes on the money you invest into them.

Traditional IRAs

With traditional IRAs, you pay taxes when it comes time to withdraw the money for retirement. Traditional IRAs don’t allow you to withdraw your money until you turn 51 and a half years old. In addition, you must withdraw the funds you have accumulated before you turn 70 and a half years old. Because you haven’t paid your taxes yet, the IRS want to make sure it gets its share of what you have accumulated . Taxes can be deducted on money you put into a Traditional IRA on both state and federal tax returns for the year you put the money in. Money you withdraw during retirement becomes taxed at ordinary income tax rates.

Roth IRAs

With Roth IRAs, you pay taxes when you put money into the account. Anne Triana serves as the President & CEO at Curo Private Wealth, a financial planning and wealth management firm located in Reston, Virginia. She brings her expertise to college students at American University who take her course in personal finance. “As my students know, I love Roth IRAs. I recommend college students (who have earned income) fund as much as possible into a Roth IRA,” said Triana. A Roth IRA likely serves as the better option if you have the funds to pay your taxes ahead of time—that way you don’t need to worry about them when you retire.

“Roth IRAs are powerful savings tools because they are funded on an after-tax basis (ie.  you have already paid taxes on your income), your funds grow tax-deferred and you make qualified withdrawals 100% tax-free. You allow compound interest (also known as the “eighth wonder of the world” by Albert Einstein) to do its magic; and if you invest your funds properly, you will have a much larger sum of money that you can pull out tax free. On top of that, you don’t have to worry about how Congress changing the tax laws (ie. potentially increasing) will impact that asset,” said Triana.

In a Roth IRA you can’t withdraw the money until you turn 51 and a half years old. If you use a Roth IRA, you don’t have to withdraw by this age because you already paid your taxes ahead of time. You can continue to let your money build up for as long as you want.

What Happens if I take Money Out of My IRA?

IRAs have some rules. You can’t take money out of your IRA before you turn 51 and a half years of age. If you do, you will have to pay a 10% penalty on whatever amount you withdraw plus some income taxes. In other words—don’t do that. Leave the money in your account so it can grow. You will then be able to enjoy all the money you have saved once retirement rolls around. An exception to the 51 and a half rule states if you want to purchase your first home, you can withdraw a certain amount from your IRA without the penalty to fund your purchase.

The Takeaway

So even though you’re just a college student and retirement seems like forever away, open an IRA and get started funding your retirement. You can never start saving too early. Even if you don’t think you can set aside a lot each month, a little bit will go a long way. Your future self will definitely thank you.