What’s An IRA?
What is an IRA? IRAs are often touted as the best way to build a retirement fund but what exactly are they and why does everybody recommend them? I’m a firm believer in using IRAs as part of your retirement plan. Using an IRA can help provide you with thousands more in retirement income than you otherwise would have. Understanding what they are and how to use them is vital to planning for retirement.
IRA stands for Individual Retirement Plan. Simply put, an IRA is a special kind of financial account that allows you to make investments while saving money on taxes. You can open IRA accounts with most major banks or financial firms. It was originally created by congress in 1974 as part of the Employee Retirement Income Security Act (ERISA) and has since had several revisions made to it to form the IRAs we know today.
Now, before you can really understand the incredible benefits of IRAs, you need to have a basic understanding of taxes. You don’t need to be an accountant but IRAs provide benefits that directly affect income taxes so understanding how those work will open your eyes to the benefits of IRAs.
Basics of Income Taxes
Nobody likes paying taxes, but how much are you actually paying in taxes? Think about this. In the U.S., every citizen pays a basic income tax. The amount you’re taxed is based on how much you make. As you make more money, you’re taxed more for that extra money that you make and this is based on your tax bracket. The minimum amount you pay in taxes is 10% of what you make. That means if you’re paid $1000, you have to give at least $100 to Uncle Sam. In most cases, it’s going to be even more than that. If you’re a single adult and have a $60,000 salary, you’re actually only taking home about $52,260 after paying taxes!
The taxes don’t stop there. Let’s take our single adult above and call her Tommy (she hated it when people called her Tom boy growing up). Of the $52,000 Tommy took home for the year, she was able to invest about $10,000 of her money and made an 8% return for $800. Before Tommy can celebrate though, Uncle Sam comes over and says that those $800 Tommy made count as income and she needs to pay tax on them. At Tommy’s current tax bracket, that’s 24%. Tommy has to pay $192 in taxes on her profits. In fact, if Tommy continued to see her $10,000 investment grow, at 8% annually, over 30 years she would end up with an account balance of $58,000 but would have paid $15,000 in taxes!
After all is said and done, Tommy has almost $8,000 in taxes for the year! If Tommy instead used an IRA, she could have paid $6,530 saving her over $1,400 and wouldn’t have to pay any of the $15,000 tax from her future investment growth. It may sound like some form of tax evasion but I assure you it’s completely legal. Let me explain this magic.
IRA Benefits and Limitations
One of the main benefits of IRAs is that they allow you to reduce your taxable income. It’s one of the incentives to encourage people to save for retirement. For Tommy’s $60,000 salary, without an IRA she has to pay taxes on all the money she made based on her tax bracket. If she used an IRA and put $5,500 toward retirement, her taxable income is reduced by $5,500. So instead of paying taxes on $60,000, she only has to pay taxes on $54,500. With less money being taxed, she ends up with a lower tax bill.
The other benefit of IRAs is that they provide tax free growth. So profits made from the sale of investments in these accounts aren’t taxed at all. If Tommy had her $10,000 investment in an IRA, she wouldn’t have had to pay any tax on her $800 profit! Since she wouldn’t have to pay taxes on the profits, she could reinvest them and over the same 30 year period as before, her account would be worth just over $100,000. That’s nearly double the $58,000 she would have if she paid taxes!
IRAs are great but they do have limitations. The government can’t let you get away tax free with everything so they put some restrictions on what you can and can’t do with IRAs. For example, the most you can put in your IRAs each year is $5,500 ($6,500 if you’re 50 or older), which is referred to as your contribution limit. This limit applies to the total contributions to all IRAs if you have multiple accounts. If you try to put more than that in your accounts, you’ll have to withdraw it, any associated profits, and pay regular tax on it. If you don’t do that before your tax deadline for that year, you’ll have to pay the IRS a 6% penalty until you do withdraw it.
For higher income individuals who also have access to a retirement plan at work, there are limits on the tax benefits you get. The taxable income reduction starts to phase out once you make $63,000 for single individuals or $101,000 if you’re married. The table below from the IRS website shows how your income affects your ability to reduce your taxable income. If you’re in the category that only allows for a partial deduction, use this worksheet on the IRS website to determine how much you can deduct from your income. Even if you don’t qualify for the taxable income deduction, you should still use your account to provide tax free growth until retirement.
Filing Status Modified Adjusted Gross Income Income Deduction Single or head of household $63,000 or less a full deduction up to the amount of your contribution limit. more than $63,000 but less than $73,000 a partial deduction. $73,000 or more no deduction. Married filing jointly or qualifying widow(er) $101,000 or less a full deduction up to the amount of your contribution limit. more than $101,000 but less than $121,000 a partial deduction. $121,000 or more no deduction. Married filing separately less than $10,000 a partial deduction. $10,000 or more no deduction.
In addition to the income restrictions, money placed into IRAs can’t be withdrawn without penalty until you reach age 59½. There are a few exceptions where you can withdraw without penalty for qualified expenses but in general, if you want to withdraw the funds before 59½, you’ll have to pay 10% of whatever you withdraw to the IRS as a penalty on top of your normal income tax. Once you reach 59½, you can withdraw the funds and they’re taxed at your current income tax rate. You’ll also have to start making Required Minimum Distributions once you hit age 70½.
What About Roth IRAs?
Everything I’ve mentioned so far has applied to what’s known as a traditional IRA. This is the most commonly used IRA but Roth IRAs are another type of account you should consider. Roth IRAs were introduced in the Taxpayer Relief Law of 1997 by then Delaware Senator William Roth. Roth IRAs offer the same tax free growth that traditional IRAs offer but contributions to Roth IRA accounts aren’t tax deductible. Instead, withdrawals from Roth IRA accounts are tax free as opposed to being considered taxable income like in traditional IRAs. If you have both traditional and Roth IRAs, contributions to your Roth IRA count towards your contribution limit for the year.
Roth IRAs also have higher income limits. If your income is too high to gain any tax benefit from traditional IRAs, you can likely place the money into a Roth IRA account so you can reap some tax benefits when you take the funds out.
With Roth IRAs, you want pay more attention to the income limits. Traditional IRAs lose their tax benefits as your income increases but you’re still able to contribute to your account up to your contribution limit. Roth IRAs, on the other hand, actually decrease your contribution limit based on your income. For most households this won’t be a problem, since the income limits are so high.
Roth IRAs allow more flexibility in what you can withdraw as well. You can withdraw the amount you’ve contributed at anytime, tax free and without penalty. Once you reach 59½, and your first contribution was at least 5 years ago, you’ll be able to withdraw as much as you want. There are also no Required Minimum Distributions so you can continue to let your account grow tax free.
Which One Should You Choose?
Choosing between a traditional and Roth IRA comes down to whether you want to pay taxes when you put the money in or take the money out. If you’re in a high tax bracket and expect to pay lower taxes in the future, you may want to go with a traditional IRA and take the tax benefits now. If you’re early in your career and expect to pay more in taxes during retirement, a Roth IRA may provide more money in the long run. Either way, you’re going to get the tax free growth. There’s no rule locking you down to a single type of IRA so it’s best to have both a traditional and a Roth IRA to use as your financial situation changes.
