August 17, 2011

Money & Career, Personal Finance

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

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.

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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. 

 


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