Since we’re deep into tax season, the one time of year when people think about their retirement accounts and investments, we thought we’d try to shed some light on one of the least understood types of investment products – the IRA. For many folks, the IRA is a vague “way to save money”, complicated, misunderstood and overwhelming. So let’s take some of the mystery out of it. The basics:
- IRA stands for Individual Retirement Account
- The IRS says they are designed as a way to make tax-deferred investments to provide financial security when you retire
- You can contribute $5,500 a year to your IRA ($6,500 if you’re over 50)
- There are two types of common IRAs, a traditional IRA and a Roth IRA
- Traditional means you usually get a tax deduction when you put money in, but are taxed when you take your money out of the IRA
- Roth means you get no tax break up front but don’t have to pay taxes when withdraw your money .
That was the crash course in IRAs, so if you just wanted to know what an IRA is you can stop reading. If you’re really interested in IRAs, here’s the rest of what I found. While researching this blog post, I somehow ended up on the IRS website reading through the rules and regulations regarding the contribution, deduction and distributions of IRAs. And they’re complicated. Since I’m not a CPA with 30 years of experience I can’t tell you which IRA is going to best protect your financial future, but I can tell you about the different options.
Traditional IRAs are taxed when the funds are distributed, so contributions are not counted as taxable income for the current year (depending on if you are covered by a retirement plan at work and your adjusted gross income), but will be taxed in the year you take the money out, at whatever rate you are taxed at that time. With a Roth IRA the money you invest is still considered taxable income, so it is taxed in the year and at the tax rate you are currently in, but won’t be taxed when you take it out.
Remember that $5,500 I mentioned earlier? Well that number comes with some caveats, mostly having to do with your income. With Traditional IRAs you are always allowed to make the maximum contribution, no matter how much you make, but you are only allowed to deduct that contribution (remember it’s not considered taxable income…sometimes) if you aren’t covered by a retirement plan at work or have a retirement plan through work and make less than $60,000. By the way a $5,500 deduction from $60,000 is huge. If you are making more than that, you can sometimes still make a partial deduction, but like I said I’m not qualified to tell you what to do with your money…might be a good question for a real financial advisor (on that note: consult your bank or financial institution, but be aware that some financial advisors will only talk to folks above a certain – very high – income level, and anyone below that threshold may have to use an online or phone option. For one-on-one financial advice your best bet may be a credit union. Greater Nevada Financial Advisors, for instance, will help you out regardless of income).
Roth IRAs kind of work the same way, you have a maximum contribution limit of $5,500 as long as you make less than $114,000 in gross adjusted income. If you’re reading this and make more than that and you want to learn more about your IRA options, go talk to a financial advisor…seriously. Roth IRA contributions are taxed when they are invested (as part of your income). This may seem like a bad deal compared to the tax deferred traditional IRA, unless you’re say…an entry level marketing professional who is in the lowest tax bracket. Why is that a good thing? You’re taxed at that low rate now, so later when you will probably be at a higher rate you won’t be taxed on that money.
Also, you will only be taxed on the principal payment, if you wait until you’re 59 ½ to withdraw interest. So let’s play with our handy Scottrade IRA Calculator. If you started maxing out your contribution at 25 years old, then by the time you were 65 you would have contributed a total of $220,000. With a rate of 8%, that original contribution would end up being about $1.4 million. The question you should ask is, “would I rather pay taxes on $215,000 or $1.4 million?” Again not everyone has the option to use a Roth IRA, but I’m just saying the taxes on $1.4 million at a 15% interest rate (which will probably be higher by then) would be about $214,000…food for thought.
Another cool thing about Roth IRAs, there is also no early withdrawal penalty for taking out your original contribution, because you already paid taxes on it. That makes Roth IRAs a nice safety net for young people, like me, who may need quick access to their money, but still want to contribute to their retirement.
That wasn't so scary, was it?
These differences don’t make one type of IRA inherently better or worse, it just means one might fit your financial needs better at a given time. Many people actually switch between Roth and Traditional IRAs throughout their life. If you’re young and looking to start saving in an IRA, this article by USA has some good tips. If you’re more established and looking to ramp up your retirement savings or hope to add some deductions to your taxes, the best advice I have for you is to talk to a financial advisor because you really don’t want to end up owing extra taxes.
In general IRAs are a great way to save for retirement, and if used correctly can make for a much easier financial future. So if you just save a little now you don’t have to worry. And for motivation here’s an article about someone who maxed out her IRA making $28,000. If she can do it so can you.