It's relatively easy to buy tangible products. You can slide your foot into a shoe and know if it's comfortable and attractive, or grasp a putter and know if its weight and grip feel good in your hand. A retirement plan isn't quite as simple. You need to know how much you want to save, what investments to put your money in, and when it's advantageous to use the various tax-sheltered savings plans. It takes a certain amount of research to understand fixed vs. variable investments, and traditional vs. Roth IRAs.
Fixed vs. Variable
There are many ways to differentiate investments. One large difference is how they generate a profit from your initial capital. Fixed investments provide a simple, guaranteed return. If you purchase a one-year CD paying 1.5 percent, you know exactly how much that investment will pay. Variable investments, such as stocks or mutual funds, will increase or decrease in value with the markets. You might see higher returns, or you might lose part of your capital. Either fixed or variable investments can be held in your IRA. An IRA filled with fixed investments is sometimes called a "fixed IRA," though this is a misnomer.
It's a common mistake to think of your IRA as an investment. It isn't an investment in its own right — think of it more as a box you can keep your investments in. Better yet, it's a cloak of invisibility because it shields the growth of your investments from taxation. This lets your money grow faster than it otherwise would, and when the effect is compounded over a period of decades the impact can be substantial. There are several forms of IRA, but the two mostly used for retirement are Roth IRAs and traditional IRAs.
Roth vs. Traditional IRA
The primary difference between a Roth IRA and a traditional IRA is how they're taxed. The government allows you to deduct contributions to a traditional IRA from your income, effectively deferring taxation until you start taking a retirement income from your investments. A Roth IRA is paid in after-tax dollars. You don't get a tax deduction when you contribute, but -- because you've already paid tax on the money you contributed -- the income you draw from it will be non-taxable. A traditional IRA is advantageous if you anticipate paying lower taxes in retirement, while a Roth IRA is advantageous if you expect to be in a higher bracket when you retire.
Holding Fixed Investments
When you start your IRA, you'll probably invest most of your capital in higher-return vehicles such as mutual funds or stocks. Over time, as retirement approaches, your priority will shift to preserving your capital rather than growing it, and fixed-return investments will become more important. Interest income is taxed at a higher rate than capital gains or dividend income, so it makes sense to tweak your portfolio to keep high-tax fixed investments within your tax-sheltered IRA, and pay taxes outside the IRA on lower-tax capital gains and dividend income.
- Jupiterimages/Comstock/Getty Images
- If My Tax Sheltered Annuity Is Losing Money Should I Cash It In?
- CDs Vs. Money Markets
- Are Long-Term IRA CDs Changeable?
- The Differences Between CDs and Money Market Accounts
- How Does a Joint and Survivor Annuity Work?
- A Guide to Tax-Free Real Estate Investments
- How to Use CD & Money Market in Retirement Planning
- The Advantages of a Money Market Hedge