A Young Man’s Guide to Understanding Retirement Accounts: IRAs

by Brett & Kate McKay on August 17, 2011 · 34 comments

in Money & Career

Today we continue our two-part series on understanding retirement accounts. Last time we took a look at employer-sponsored retirement accounts like 401(k)’s and 403b’s. Today we’ll be discussing retirement accounts that you can open up on your own without the need for an employer–the Individual Retirement Account or IRA.

Let’s get started.

What Is an IRA?

An IRA is simply an account that you can shelter your retirement in to help you save on taxes. It’s super easy to open an IRA. You just need taxable income and to complete a little paperwork. You can open up an IRA at most banks or investment firms.

After you open an IRA, you can fund it with any type of investment you want–stocks, mutual funds, bonds, or index funds. I have an IRA with Vanguard and use a simple index fund to fund it.

Note: What follows is based on the tax laws governing IRAs in 2011. They’ve changed before and will change again. Check out the IRS’ page on IRAs to stay up to date on IRA rules.

The Ins and Outs of Traditional IRAs

Tax benefits of traditional IRAs. The money you put into a traditional IRA can be deducted from your taxable income for that year, thus reducing your immediate tax liability. Your money will sit in your IRA growing and growing without being taxed every year. You aren’t taxed on the money you put into a traditional IRA until you withdraw it at retirement. I think it’s easier to understand this concept when you see an actual example:

Let’s say you make $50,000 a year at your job and you decide to set aside $5,000 a year for retirement in your IRA. That $5,000 will go into your account, but at tax time, you’ll only be taxed for $45,000. For the next 40 years that $5,000 you put in your account will grow tax-free. When you retire and start making withdrawals from your account, the money will finally be taxed.

Because you pay your taxes on your money later, traditional IRAs offer tax deferred growth.

Contribution limits. The largest amount you can contribute to your traditional IRA in a year is $5,000. It’s much less than what you can contribute to a 401(k), but if you don’t have access to a 401(k) plan, it’s better than nothing. Remember, you can deduct that $5,000 from your taxable income at tax time. Also, this is $5,000 TOTAL. If you have more than one IRA, the limit applies to the total contributions made to all of your traditional IRAs. When you’re 50 years old or older, you’re allowed to save an additional $1,000 a year to catch up your savings as you prepare for retirement. If you contribute more than $5,000 a year, you’ll be hit with a 6% penalty on the amount you went over. So keep track of how much you’re investing!

Ability to deduct the full $5,000 contribution depends on a few factors. It would be nice if the IRS made it simple and always allowed you to deduct the full $5,000 you contribute to your IRA from your taxable income, but we know the IRS doesn’t like to make things easy. Consequently, we have a bunch of rules that muddle things up.

Two factors that determine whether you’re eligible to deduct the full $5,000 from you taxable income are 1) your adjusted gross income and 2) whether you have access to an employer-sponsored retirement account.

  • If your employer DOES NOT offer a retirement plan, you’re almost always allowed to deduct your full $5,000 contribution to a traditional IRA.  There’s a small exception to this rule–if your company doesn’t offer a retirement plan, but your wife’s company does, you can make the full contribution ONLY IF you and your wife’s combined gross income is $166,000 or less AND you and your wife file your taxes jointly.
  • If your employer DOES offer a retirement plan, your traditional IRA contribution might not be fully deductible. Let’s say your employer offers a 401(k) plan, but you decide not to participate in it and instead opt to open up a personal IRA in order to keep more control over which investments you can choose. This rule means that you might not be able to deduct that full $5,000 IRA contribution from your taxes that year. You probably guessed that this rule is in place to encourage people to use their employer’s retirement plan.

This rule also means that you can have both an employer-sponsored retirement account and a traditional IRA. Again, you just might not be able to deduct the full $5,000 IRA contribution from your taxes.

Okay, so how do you know if you can deduct the full $5,000 contribution? It all depends on your adjusted gross income.

You can deduct the full $5,000 if:

  • you’re single and your adjusted gross income is $56,000 or less; or
  • you’re married, you file a joint tax return, and together your gross adjusted income is $90,000 or less.
  • you’re married, but you and your wife file separately, and your personal adjusted gross income is less than $10,000.
If you aren’t eligible for the full $5,000 deduction, figuring out how much you can deduct takes some work. Use this worksheet provided by the IRS.

Withdrawing from your traditional IRA. You can begin withdrawing your money from your traditional IRA without penalty when you’re 59 and 1/2 years old. If you withdraw early, you’ll have to pay the income taxes that would normally be due on your withdrawal PLUS an additional 10 percent as a penalty. The IRS makes some exceptions when it comes to this penalty. Exceptions include using the money to pay for educational expenses and health insurance premiums or to buy your first home.

The IRS doesn’t allow you to keep your money in your traditional IRA growing tax-free forever. At age 70 1/2 you have to start making minimum distributions from your account. If you don’t, you have to pay a penalty. Bummer.

Roth IRAs

The Roth IRA was created in 1997 by Senator William Roth of Delaware. Let’s take a look at some of the differences between the two.

Tax benefit of Roth IRAs. This is probably the biggest difference between traditional and Roth IRAs. Unlike with traditional IRAs, you don’t get the upfront tax break when you contribute to a Roth IRA. You invest after tax dollars into your account. While you don’t get the upfront tax break when you invest with a Roth IRA, you don’t have to pay income taxes on your money when you finally withdraw it.

So let’s say you invest $5,000 into your Roth IRA, and forty years later when you retire it’s worth $8,000 (This is just an example. Could be more, could be less). When you withdraw that $8,000, you pay no taxes on it. Roth IRAs offer tax-free growth.

Contribution limit. It’s the same as the traditional IRA. $5,000 a year ($6,000 if you’re 50-years-old or older).

Your ability to contribute the maximum $5,000 depends on your income. 

Unlike with the traditional IRA, you cannot deduct your yearly contribution to your Roth IRA from your taxable income. And there are also rules on whether or not you can contribute the full $5,000 at all. You can contribute the full $5,000 if:

  • you’re single and your adjusted gross income is not more than $107,000
  • you’re married, file taxes jointly with your spouse, and your adjusted gross income is not more than $169,000

If you make more than those limits, but less than $179,000 (for married couples filing jointly) or $122,000 (for singles or married couples filing separately) you can still contribute to a Roth IRA, but you can’t contribute the full $5,000. To figure out exactly how much you can contribute if you make more than the income limits, use this worksheet provided by the IRS. If you make more than the $179,000/$122,000 limits, you cannot contribute anything to a Roth IRA.

Another nice feature about Roth IRAs is that you can contribute to them in addition to contributing to your 401(k) at work without being hamstrung by the rules governing the traditional IRA.

Withdrawing from your Roth IRA. You can begin withdrawing from a Roth IRA without paying any taxes when you reach age 59 and 1/2.

But you can withdraw early from a Roth IRA if you want. You don’t have to pay a penalty for early withdrawal like you do with a traditional IRA. You’ll just have to pay taxes on any earnings your investment made while in the Roth IRA.

My suggestion is to avoid withdrawing the money until you’re 59 1/2, so you can take full advantage of the tax-free growth Roth IRAs provide.

You can also avoid paying taxes on earnings for early withdrawals if you’re going to use the money for a first home or to cover a disability.

Unlike traditional IRAs, you can keep your money in your Roth IRA as long as you want. You’re not required to make minimum distributions at age 70 1/2.

Should I Open a Traditional or Roth IRA?

Short answer: It depends.

Long answer: You need to take inventory of your financial status now and make some predictions on what you think it will be down the road.

  • Generally, if you think your tax rate during retirement will be lower than it is today, it’s best to take advantage of the tax deferred growth of a traditional IRA.
  • If you think your tax rate during retirement will be higher than it is today, it’s best to take advantage of the tax-free growth of a Roth IRA.

Because it’s generally assumed that young people starting off in their career will retire in a higher tax bracket than where they’re at now, most financial experts agree that Roth IRAs are best for young people. Traditional IRAs are better for older individuals who will probably retire in a lower tax bracket than the one they were in during the peak of their career.

Of course there are other factors to consider that are impossible to predict. Will the national debt problem continue unabated and will taxes rise in order to pay for it? Will the country fifty years from now be a socialist or libertarian utopia? If only we had a crystal ball!

I personally prefer the Roth IRA because of my embrace of the power of delayed gratification. I love taking on some pain now, knowing that I’ll get to enjoy the fruits of my sacrifice later. It’s just psychologically satisfying.

_________

Well, I hope this little introduction into the wonderful world of retirement accounts was helpful. If you haven’t gotten started with saving for retirement, I challenge you to start today.  You don’t need much to get started and you don’t have to contribute that much each month. In the long run, every little bit helps.

What have been your experiences with IRAs? Did I leave anything out? Any advice to the young men out there just getting started with saving for retirement? Share your insights with us in the comments. 

 

{ 34 comments… read them below or add one }

1 reinkefj August 17, 2011 at 11:40 pm

I’m not a financial adviser. Not registered. Not certified. Not nothing. I have gray hair. And, I’ve worked on Wall Street.

In the example given of a 50k employee, I caution that the 5k “savings” decision should be very carefully considered. There are some “hidden assumptions” that should be considered. It may be the right decision to go the tax deferred route, but eyes should be wide open.

I can think on two BIG concerns and one not so big one.

First big one, if our 50k employee doesn’t have a sufficient emergency fund and has to tap that tax deferred saving, bad news. A 10% penalty when money is short is very painful. I’ve heard people wish they’d never done it. I have my ideas about how big an e-fund should be. The lousy economy and such means bigger is better. Depending upon unique circumstances, I’ve recently recommended an e-fund of 5 years of burn rate to a 57 year old laid off exec. Your mileage may vary.

Second major one, the investment options have to be carefully examined; the fees can reduce growth rates. And, look at Japan’s lost decades and the USA’s market in the 60′s and 70′s. Bad returns might be the least of one’s problems. Using the “retirement saving” to reduce a mortgage might be a better form of savings. Your “retirement savings” could have a negative real rate of return.

Third minor one, the Gooferment is broke. They are looking for wealth. They owe 14T$ and it ain’t going down anytime soon. There’s a lot of money in “deferred accounts” — guesstimated between 10 and 20T$. From time to time, there is talk (trial balloons in DC) about “exchanging” the retirement money for an “enhanced Social Security benefit”. I rate this as a low probability (cause people would be irate), but it should be on one’s radar.

Hope this helps.
fjohn

2 JS August 18, 2011 at 12:24 am

Thanks for the post, was helpful. I’m new to all of this, but I have a question.

Even for younger people, should a traditional IRA be considered if you expect positive market returns or positive returns in whatever area you plan to invest the money? Assuming you use a market index (and only a single market index for this example) for your IRA, aren’t you better off going traditional because by not having the taxes removed as they would be in a Roth IRA don’t you have more money to invest? In other words, $5,000/year in your IRA gets invested instead of $5,000 minus taxes/year?

Any insight on this or am I completely misunderstanding it?

3 Westicles August 18, 2011 at 8:23 am

JS you are correct. You have to look at it as prefunding your tax liability. Say (like above) you put $5,000 minus 25% taxes into a ROTH IRA ($4750). If you let it sit for 40 years at a 6% rate of return (this is a rough calculation so compund I compounded yearly) you will end up with around $49,000. That is YOUR money and will not be taxed.

On the other hand, if you invest $5,000 into a traditional IRA (using the same assumptions above) you will end up with around $51,500. This is a taxable amount.

4 Brian August 18, 2011 at 9:49 am

Great article Brett. Fun fact that many people don’t know: IRA doesn’t actually stand for Individual Retirement Account (even though that sounds better IMHO), but actually in the Tax Code it stands for Individual Retirement Arrangement.

And Westicles, I disagree with your numbers a bit. I think your figure of $4750 should actually be $3750, and using that number, after 40 years the principle grows to $38,570.

Roth IRA accounts allow you to invest more, because the maximum $5000 is worth more when you have already paid taxes on it. I also like Roth’s more because the value you see is the actual value, not the pretax value. Just personal preference.

5 JF August 18, 2011 at 9:54 am

I personally worry that the government will decide in the future that Roth account holders are a good place to look for extra tax revenue and will change the status of the accounts. There would be an uproar for sure, but most people don’t save enough for retirement, and the ones who do have accounts are “rich” in the eyes of the government so in their eyes (and in the eyes of a majority of voters who don’t have large retirement accounts) they are only imposing pain on people who can afford to bear it. Better in my opinion to take the guaranteed current reduction (via the IRA deduction) in taxes than the possibility for tax free retirement. I don’t qualify for a Roth or to deduct my IRA contributions, but I still contribute the maximum to a traditional IRA to shield some of my capital gains and investment income from taxes.

6 Ben August 18, 2011 at 10:05 am

I started late to the game with saving for retirement, which is the frequent stupid mistake of youth. I found Ramit Sethi’s book “I Will Teach You To Be Rich” to be helpful for a full financial overhaul. I’m in a relatively fantastic position compared to where I was two years ago. That said, once I decided to focus on retirement, I went in this order:

1. Emergency fund. Determine how much that needs to be based on your life and get that set.

2. Max out employer-match on 401K. The employer match is essentially free money, so I contribute the amount to take full advantage of what they’ll match. Where I work, that’s 6%.

3. Setup Roth IRA. I could probably do best by investing in an array of Index Funds, but worrying about picking the right ones had me not setting up my IRA at all. After a year of inaction, I settled for the easiest option: a Vanguard target-date fund. It’s automatically balanced over the lifetime of the account and all I need to do is keep donating.

4. Once I get to a point where I’m maxing out my Roth IRA – which likely won’t be for a few years at my current rate of salary increases – I’ll bump up my 401k contributions.

7 Ian August 18, 2011 at 10:48 am

This is a great article, and I appreciate the debate in the comments too. My employer recently provided a Roth IRA option and the financial adviser explained things about the same way as this article. I opted for the ROTH over traditional, but in essence I now have both: my contributions are taxed to be put into the ROTH, while the employer’s contributions are 401k. Any thoughts on this combination?

8 Justin August 18, 2011 at 11:51 am

For a young man, Roths are great due to compounding interest. I would much rather be taxed on the $5000 that I am putting in today than on the amount that it will have grown to later (especially given the whole higher tax bracket part). As someone else mentioned, if you are maxing out, it will be more effective overall. The roth will have $5000 invested, and will never be taxed. The maxed out traditional IRA will have $5000 invested, but will be taxed at the end, which will take a huge bite out of your savings.

9 Colby August 18, 2011 at 1:57 pm

In one of your next articles, can you cover what “stock options” are? I have learned before but not in a way that sticks. Your article here was very well written and the clear examples should allow it to stick a lot better. Thank you.

10 Curt Weil August 18, 2011 at 2:51 pm

Good article/explanation, and the follow-on comments are also good.
A couple of notes: while your IRA contribution may be FEDERALLY tax deductible, it isn’t always STATE tax deductible. California, for instance, hasn’t always followed the Feds on the deductible amount, so some of my IRA contributions are after-tax for CA calculations upon withdrawal. Makes it very worth-while to keep good records.
As for what the Feds might or might not do in the future regarding taxation of retirement accounts, my crystal ball has too many flaws in it to give an answer.
If you are interested in lots of technical info, used by professional financial advisors, see: http://www.irahelp.com/ written by Ed Slott, CPA. Morningstar also has a very good newsletter on IRA matters.

11 Rob from Richmond August 18, 2011 at 5:15 pm

I have a question about making contributions. I have a 401(k) at work and also a Roth IRA. I will be returning to work, but right now I am on workers comp disability following an accident. I know I can’t contribute to my 401 (k) while disabled, because I have no work income, but I want to continue to contribute to my Roth. My current income (disability benefits and insurance settlement) is un-taxed. Can I still contribute to the Roth, or do I keep it in savings until I return to work and have declarable income? I’m in Virginia, if that makes any difference. And thanks for a great article.

12 Matt August 18, 2011 at 7:02 pm

Nice article, thank you.

You mentioned in this article that you might be able to withdraw your IRA without penalty to buy your first home. I took a look at your article on 401ks and didn’t see mention of the same policy there. Do you know if that is common as well?

Thanks in advance!
Matt
Minneapolis

13 Jeremy August 18, 2011 at 9:42 pm

Please note I am not a tax adviser, but am a CRPC.

You can avoid penalty on first time home purchase (or if you haven’t owned one for 2-3 years) from w/d only from IRA. This does not apply to 401(k) plans.

Also, if you w/d from the roth IRA before 59.5 not only may the earnings be taxable as ordinary income but my understanding is that you will be subject to the 10% penalty as well on the earnings. I confirmed this here.
http://www.fool.com/money/allaboutiras/allaboutiras07.htm

Another helpful note. You can, regardless of income, currently convert any traditional IRA into a Roth IRA. In this scenario you pay ordinary income taxes in the year you convert the account and they grow tax free until retirement. This is often helpful to high income earners who want to get some roth funds.

Additionally, if your employer offers a “Roth 401(k)” option, this is subject to the higher 401(k) contribution limits and (16,500 annually or 22k annually if 50+ years) not subject to the income limitations.

14 Jeremy August 18, 2011 at 9:44 pm

Oh and the 1st time home purchase penalty exemption has a lifetime cap of 10,000.

15 Brett McKay August 18, 2011 at 10:07 pm

Thanks for all the great insights and additions everyone! Great stuff.

@Ian- If you’re going to go the combo route, I think Ben’s set-up is pretty good.

@Rob from Richmond- The following sources of income are not eligible compensation for the purposes of making contributions to a Roth IRA:

-rental income or other profits from property maintenance
-interest and dividends
-other amounts generally excluded from taxable income

Disability would fall under that last category, so unfortunately no, you can’t contribute to a Roth IRA with your disability money. Keep saving and when you’re back to work, start investing again.

One way you may be able to get around that is if you’re married and your wife works and makes enough money to cover your contributions. It’s called a Spousal IRA: http://www.smartmoney.com/retirement/planning/spousal-iras-7956/

You might check with an investment company to see if that’s an option.

@Colby- We’ll definitely write an article on stocks and stock options. On a similar note, would you all be interested in some posts about basic economic principles like how inflation and deflation work, how are interest rates set, etc? Personally, it’d be a great exercise for me. They’re concepts I hear all the time and learned about a long time ago, but they never stick.

@Matt- As Jeremy mentioned, you can only withdraw early from an IRA to help pay for your downpayment on a first time home. While you can’t withdraw early from a 401(k), you can BORROW from your 401(k) for a home purchase. You just have to pay the money back into your account in a certain amount of time or else you’ll have to pay a penalty fee and pay taxes on the amount you didn’t pay back. The pay back time varies from plan to plan, so check with yours before you decide to borrow from your 401(k).

16 Wesley August 18, 2011 at 11:37 pm

@Brett – Continuing this series with basic economic principals is definitely something I’d enjoy getting your take on. While it may not be considered “basic”, I’ve never understood what the heck “shorting a stock” means or how that works. If you could work that into a portion of a financial post, I’d feel a bit more confident when I hear that term batted around.

@reinkefj – Great points! I enjoyed reading your contribution.

I read quite a few finance-related blogs (GRS, IWTYTBR, Simple Dollar, ERE, etc). While those are all great sites, I enjoy Brett’s musings on most any subject. Great article.

17 Cale Smith August 19, 2011 at 7:54 am

The small business owners in the crowd shouldn’t overlook SEP IRAs, either. Depending on your circumstances, you might be able to sock away up to $49k a year in a SEP…and you’d have to be fruit-loops-crazy not to at least consider that, no?

18 R.J. August 19, 2011 at 12:58 pm

Not only do I have concern that the rules will be changed by the government, but I also fear for the value of the dollar. What good is the compound interest on your money if the purchasing power of our dollar is declining everyday? I would hold gold and silver physically before I put my money in the banks. It’s unfortunate for our generation, but I don’t think IRA’s, Roth, or Traditional will compete with commodities with the current state/policy of the Federal Reserve and this country.

19 Andrew Carroll August 19, 2011 at 9:53 pm

Awesome article but you forgot one big idea on ROTHs. You can start withdrawing penaly free at 59 1/2 AND you have to have made your first contributon at least 5 years prior. Exmple: if you open a ROTH at 56 you must be 61 to withdraw without penalty.

As a side note, on ROTHs the penalty is only assesed on EARNINGS wich means if the value of the account is the same or lower than when you started, there will effectively be no penalty. There are also some cases where FIFO (first in first out) is used. So even if you have earnings, you can consider yourself to have withdrawn “princpal” and pay no penalty.

A minor correction since, if you are using a ROTH or a Traditional IRA, you should just save the money and not spend it!

20 Josh August 21, 2011 at 11:41 am

What happens to the money in your IRA if you die before you can use it all?

21 Jeff Rose August 22, 2011 at 1:30 pm

@Josh

With IRA’s, like other retirement accounts and insurance policies, you list a beneficiary(ies). A single person would usually list their parents, while others would list a spouse. They would then inherit the IRA as is.

There are some other issues regarding the potential tax aspect, but probably beyond the scope of your question.

In summary, whomever you list gets it. If you don’t list anyone, then it goes to your estate and a probate court will decide who gets it. That’s why it’s best to always list a beneficiary.

I had a instance where a clients mom did not double check the beneficiaries on one of her accounts. The outcome was not pretty: http://www.goodfinancialcents.com/beneficiary-review-designation-form-life-insurance-retirement-accounts/

22 Jon August 23, 2011 at 9:24 am

My understanding is that you can withdraw the principle amount you have contributed to a Roth without penalty. Not earnings, just the amount of contribution. The idea is that this amount has already been taxed. Does anyone know if that is wrong?

Also, I have always wondered whether the $5,000 limits of the traditional and Roth IRA’s are exclusive. I am not in a financial position to max my contributions to both, so I don’t have personal experience with this. But could you fully fund one of each account? I assume that the $5,000 limit applies to all of your IRA’s, Roth or otherwise.

23 Sam August 26, 2011 at 12:33 am

Clarification(s):

1. Early withdrawals from Roth IRA’s are generally subject to 10% penalty, but not taxed as income unless in excess of their cost basis (sum invested).

2. Lot of sketchy math going on here. Choice between Roth IRA v. IRA has nothing to do with ‘compounding gains growing tax-free’ or interest and principal returned tax-free. Only factor is tax rates. If you think they will be higher when you retire than what you pay now, Roth is the choice; if lower during retirement choose traditional. It is true the Roth option allows you to save more as it is an after tax contribution. Other factors to consider are that many younger/middle aged people have mortgage/student loan/other deductible debt while younger that lower their effective taxable income. You hope to be done paying those off by retirement, thereby increasing your effective income.

Last point about why traditional IRA’s are funny: Who wants to retire making less, nominally, than they do today? Either that or they think tax rates are going down, which is highly unlikely over the long-term.

24 Brian August 27, 2011 at 5:41 pm

Disclaimer: I am not a registered financial professional, but a concerned (and informed, I like to think :) ) American.

I absolutely agree with you both and encourage your explaining the different options people have when it comes to retirement plans. It’s fantastic!

It is critical, though, Brett and Kate, to have an understanding of the trends in the actual value of a particular currency before diving into a long-term savings plan that are denominated in just one currency, like a 401(k).

I hope you will be cautious in recommending investments that are based solely in devaluing currencies like the US dollar.

As 401(k) plans mainly invest in the common stock of American companies, I hope you both understand that the average 401(k) investor will largely be at a net loss in actual purchasing power by the time s/he has access to the plan’s monies.

I submit for your review a of couple points I hope you consider when looking beyond the pro’s of investing (like company matching and tax deferment – which actually may turn out to work against you) in a 401(k) as your primary retirement vehicle:

1. Inflation.
Consider the affect the trillions of dollars in stimulus and bail-out funds are having on the value of our currency. Also consider the effect T-bills that are currently owned by other countries and non-nation sovereign wealth funds will have on the value of our currency when they mature.

2. The priority of common stock dividends.
The executive teams that run the businesses in which your 401(k) invests don’t always have the common stock holder’s best interests in mind. If a company in your portfolio is bailed out by the government, that lender is the first on the list to pay when a business makes money. Next is the corporate bondholders. Then preferred stock holders. Then the company has the option to hold any extra money as retained earnings. If the company wants to only hold some, or none at all, then a dividend payout is awarded to the common stock holders.

3. The fate of the companies in which were invested.
The assumption the companies that are being invested in by the 401(k) will not only be around by the time you retire, but have continually expanded (particularly in stock price and future earnings potential).

4. A buyer of your stock.
The assumption a third party will be willing to pay for the (hopefully) higher price of the stock when you retire. Hopefully the gains in the stock price out-pace inflation, and…

5. Taxes.
The assumption that the tax you will pay in the future on both the principal invested (since you deferred tax when you put the money in) and the capital gains that you made over time aren’t higher than they are currently. They certainly won’t be lower, but if they are higher when you want to take the money out, hopefully the returns your 401(k) made not only beat inflation, but also can handle the bigger chunk the government will take out in taxes.

I’m not trying to undermine your article, but provide another perspective on the options you both discuss. Keep up the good work!

25 John September 1, 2011 at 4:37 am

I’m surprised you left out SEP and Simple IRAs. You have self employed income, these can make far more sense than Roth, and have higher contribution limits.

26 Diane Galemmo December 17, 2012 at 5:18 pm

Can IRA money be withdrawn before
59 l/2 for an emergency situation?

What constitutes an emergency?

27 robert February 6, 2013 at 5:11 pm

can you buy after tax IRA’s.Say I have maxed everything and have 20,000 dollars sitting in the bank that I have already earned and payed taxes on.Can I buy an IRA ?

28 nick April 1, 2013 at 11:01 pm

Consider these cons of a traditional IRA.
1. You can’t touch it till you’re at least 59.5 years old. If you do, your hit with a 10% penalty + the tax.

2. You have no control over the return you will earn. When you put your money in the hands of other people you lose control. Keep in mind, it’s much easier to overcome losses than people think, If you lose 20% in one year, you’ll have to earn 25% the following year just to be back to “break even” Losses early on can be devastating.

3. It’s a “poor-mans” way to plan. I personally believe based on the way our government has been managed in the past and will be managed in the future taxes are only going to increase in the future. Traditional IRA distributions are taxed at your ordinary income tax rate when you begin taking them. Unless you plan on being poor and earning no money during retirement (hopefully you’ve made solid investments that generate a passive income) you will be taxed much more at retirement than just taking you lumps now and freeing that money up to do whatever you want with it.

4. Lastly, think about this point. This is a government retirement plan. Who do you think the government is really looking out for? You or them? It’s rigged up to save you a little cash now through a lower taxable income, but to break your bank in the future when you’ll need the money the most.

29 nick April 1, 2013 at 11:02 pm

Correction: On point 2 I meant to say, “It’s much HARDER to overcome losses than people think”

30 jimb May 5, 2013 at 1:32 pm

There seems to be an awful lot of misunderstanding about total taxes for tax-deferred plans like 401(k) and traditional IRAs and Roth versions of the same things.

First, if your tax brackets and total percentage of taxes were the same both before and after retirement, you’d end up with exactly the same amount after taxes. The taxes you don’t pay now but invest for yourself would grow just enough to pay the taxes on the larger total after retirement.

Second, chances are your total taxes after retirement will be a smaller percentage than the amount you get to deduct for your contributions to retirement during your working years, even if taxes are increased considerably. Here’s why:

Many people use only the marginal (highest) tax bracket for comparison. Actually, with a tax deferred plan you get to defer taxes on your contributions in your highest tax bracket and invest that money now. But because of the standard or itemized deductions, personal exemptions, graduated brackets for percentages of tax, and tax credits, the total percentage of income tax paid in a year is considerably less than the top bracket.

For example:

A single person earning $70,000 contributing 15. % ($10500) to a 401(k) and taking the standard deduction of $6,100 and personal exemption of $3900 has a taxable income of $49,500. They’d pay $8,304 federal income tax, $1,015 Medicare, and $4,340 Social Security taxes. They pay their top bracket of 25.% on the top $13,250 of their income. Their federal income tax is actually only 11.86% of their wages.

The deductions, exemptions, and steps between brackets go up with inflation. So even after inflation, an extra across-the-board percentage increase of 50% in each tax bracket would still only make their total taxes about 17.79% of their income – compared to 25% that they deferred paying on their contributions to retirement.

Furthermore, after retirement you won’t need to withdraw as much from your retirement account even if you needed exactly the same take-home pay. You would not be contributing anything to to retirement and would not pay FICA taxes on any pensions, withdrawals from retirement accounts or social security income.

Depending on your income from other sources, you might not pay much if any income tax on your social security income either. In Georgia where I live you’d get to defer 6% state income tax and pay no income tax on retirement income or withdrawals from the tax-deferred accounts. Or you might defer taxes in a state that has an income tax and then retire in a state that has no income tax. In these cases, a tax deferred plan is even better.

jimb

31 Robert E. Searle September 25, 2013 at 4:31 pm

If I receive notice from an investment company that I must take a Minimum Distribution of $xxxx.xx – does that notice mean I must:
(a) withdraw or transfer that amount from the current IRA account and, then (b) report that amount as ‘income’ on Federal & State(CA.) income tax returns for the fiscal year in which the ‘distribution’ was taken?

Robert E. Searle

32 JG February 26, 2014 at 10:49 pm

I don’t make alot of money but I try the best with my financial decisions. Is an IRA a good decision for me? My company doesn’t offer a 401k or anything of that nature. I wanna plan for the future instead of working my whole life then having nothing when I’m to old to work. Can anyone give me any advice on this please.

33 Todd February 27, 2014 at 10:24 am

The article and everyone’s comments thus far are very helpful, thanks to all.
I’m looking for opinions/suggestions for my own personal situation:
I’m 40yrs old and (most likely) permanently disabled. It’s my understanding that I cannot use any disability money to contribute to either my 401k or any type of IRA. I believe I will be able to roll my 401k into my wife’s once she’s been employed for a year and can start contributing. My question is, would it be smarter in the long run to a) roll my 401k over into her 401k or b) cash out now (if that’s possible with a 401k?), pay taxes and penalty and pay off our mortgage which we are only 3 yrs into paying off?
Interest saved by paying mortgage off (not to mention piece of mind) vs. possible money earned in wife’s 401k.
Also, would we be able to waive the 10% penalty due to disability or is that only to pay for things directly related ie. health insurance, medical bills etc.
Thank you.

34 Lee March 13, 2014 at 11:51 am

What about Roth 401k? I just started investing in my company’s Roth 401k plan. Good or bad?

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