Sadly because they have the term “retirement” attached to them they A – seem dull and B – don’t seem relevant to anyone young enough to really benefit from using them. The truth of the matter however, is the that they make up a critical and tangible building block of your financial future.
What makes IRAs so special
An IRA is special because it is one of the few investment vehicles blessed by the Federal Government to allow your assets to grow tax differed or tax free (depending on the IRA you choose). For those conspiracy minded folks there is no mystery why this was done. It is both an incentive to save for your retirement and depending on what assets you invest in though your IRA (we discuss this in part 2) a way to feed fees to the financial industry.
Regardless, done correctly and with less effort than you think, you can come out much further ahead then putting money under your mattress, a CD, or other high yield savings accounts. In addition IRAs are protected from personal bankruptcy, so if you experience a financial firestorm later in life, you can at least escape with enough (if you put enough in) to live out your years modestly.
What piece of the financial puzzle is this solving
Individual Retirement Accounts are part of your long term investment strategy. They are designed support your goals and aspirations after 59 1/2 (this is a dumb number but you can thank congress for that). If you think 60 is ancient, let me tell you it isn’t. It might have been when IRAs were first instituted but if you are your 20′s or 30′s plan to live 100 or more! Life after is 60 are supposed to be your golden years or 40% of your entire life that you will benefit from an IRA so do this early and do it right.
What piece of the financial puzzle is this NOT solving
Here are a few things IRAs make no sense for…
- Emergency Fund – You’ll have your ass handed to you in form of major tax penalties by dipping into an IRA early. Make sure to have an emergency fund outside of your IRA for easy access, penalty free.
- Short Term Investments – Once you deposit funds into your IRA you can move them around into different investments (stocks, Bonds, Index Funds, etc.) but removing returns prior to the magic number of 59 1/2 comes with penalties and taxes.
- Life Insurance – You can actually mix life insurance with your IRA. Keeping things seperate keeps things simple with no surprises
- Health Insurance – There is no direct connection with health insurance and your IRA, but when your IRA does open up penalty free in you 60′s it sure can help with any medical costs not covered by your primary insurance carrier or government issued insurance (medicare, medicaid or what ever they come up with next that is not universal healthcare)
- Educational Expenses - This simply is not a place to save for educational expenses for you or your children.
Time To Choose Your Vehicle
This is the first barrier to entry both physically and mentatlly to getting your money working for you in an IRA. There are 4 primary IRA types that you’ll hear about
- Traditional IRA (first IRA available circa 1986)
- Roth IRA (introduced in 1997 named for its chief legislative sponsor, Senator William Roth)
- SEP IRA (Simplified Employee Pension Individual Retirement Arrangement)
- Simple IRA (Savings Incentive Match Plan for Employees Individual Retirement Account) – Sounds so simple
You can setup both Traditional and Roth IRAs as an individual as opposed to SEP and Simple IRA’s which must be instituted by your employer. If you are self-employed or run your own business you can also setup a SEP or Simple IRA plan for you and your employees in addition to having your own personal Traditional/Roth IRA.
For this reason we are eliminating SEP and Simple IRAs as they are either not available to you or as a self-employed/business owner you need to do a deep dive assessment with your financial planner, and other trusted advisors. Moreover, if you are in this situation you can still setup and fund a Traditional/Roth until you work out the details on the more complex IRAs.
Now on to the shootout between Traditional and Roth IRAs. Below is a quick chart for general comparison
IRA Comparison Chart
|Income Level||Based on MAGI; Single: full contrib up to $105k / partial contrib to $120k / Married: full contrib up to $173k / partial contrib to $183k; Can't contrib > annual taxable compensation||Same as Traditional||MAGI: Modified Adjusted Gross Income. This determines if you are eligibale for tax deductions for funding your IRA based on your income|
|Must Show Earned Income||Yes||Same as Traditional||You need to earn at least as much as you are funding your IRA. e.g. To fund your IRA 5k you need to declare atleast 5k income for the year|
|Funding (paying into the account)|
|Tax Implications of contributions||Contributions are fully tax deductible up to set income levels up %56K. The deduction trails off as income approaches $60K at which point there is no deduction for contributions||There are no tax deductions for contributions||This is the primary advantage of a Traditional IRA (only if you expect to be earning ~ $60k for the duration of your life)|
|Minimum Contribution Per Year||None||Same as Traditional||Most investment firms require automatic deposits of $50 or more a month to maintain an account with them|
|Maximum Contribution Per Year||5.5k Per Year until age 50 when 6.5k Per Year (known as a "catch up provision")||Same as Traditional|
|In plan tax implications||Capital gains / dividends / and interest within account incur no tax liability||Same as Traditional|
|Changing Institutions||Funds can be either transferred to another institution or they can be sent to the owner of the IRA who has 60 days to put the money in another institution in a rollover contribution to another IRA||Same as Traditional|
|Distribution of funds (when you can take money out)|
|Eligible Distribution Age||59½ or if owner becomes disabled||59½ as long as contributions are "seasoned" (5 years from January 1 of the year the first contribution was made) or owner becomes disabled|
|Required Distribution Age||Must start withdrawing funds at age 70½. Penalty is 50% of minimum distribution.||None||This is a huge advantage for Roth IRAs when estate planning.|
|Early withdrawal of principle||No||At any point the owner may withdraw the total contributed into the IRA without tax or penalty|
|Early Withdrawal of capital gains||10% penalty plus taxes for distributions before age 59½ with exceptions||Early withdrawal that is more than contributions plus seasoned conversions are subject to normal income taxes and 10% penalty if not qualified distributions|
|Early withdrawal for allowed expenses||First time home buyer down payment / Education Expenses / Medical Expenses||Same as Traditional||Please read as " You can't afford the house if you need to dip into your IRA for a down payment."|
|Multiple Accounts||Yes (but sum total of annaul income invested must be 5.5k (6.5k after age 50)||Same as Traditional||There is usually no need to have multiple accounts and you can get into trouble with the IRS for over funding. Keep it simple and keep your accounts to a minimum.|
|Convertible||Yes – known as a conversion when going from a Traditional to a Roth||Yes – known as a Recharacterization when going from a Roth to a to a Traditional||Consult your three horsement (Financial Planner / Accountant / Lawyer) if you plan on doing this right the first time|
|Distribution Taxes||All distrobutions are taxable at the tax bracket the individual is in at the time of distribution||Distributions are not taxable||This is a huge advantage for Roth IRAs as it does not add to your taxble income in your later years e.g. If you have a taxble income of $25k when you are 70 and you pull out 50k from your Roth IRA – your income tax rate is $25k not $75k.|
|Beneficiaries||The spouse as beneficiary can roll both accounts into one Roth IRA account. Other beneficiaries will be subject to forced distributions (tax free) based on life expectancy. Beneficiaries will not pay estate tax if the inheritance is under the exemption amount.||Same as Traditional|
|Protection||Account is protected from bankruptcy up to $1 million. Protection from creditors varies by state (from none to full protection).||Same as Traditional||This could your last lifeline if you have to deal with the ultimate financial crisis of filing for bankruptcy|
If your expectation is to be making under $60k per year for the foreseeable future than you can benefit from a Traditional IRA because your contributions can be tax-deductible. Otherwise, the Roth IRA has many advantages over a Traditional IRA with the highlight being
- Distributions after 59 1/2 are tax free
- You are not required to take distributions at any age
Lastly, I want to leave you with a set of charts that should compel you to open up an IRA today.
All 3 charts share following in common
- The maximum invest amount is invest each year ($5.5K up to 59 and $6.6k from 50 – 59)
- 8% average yearly return (5% is conservative and 10% is optimistic)
- I don’t factor in inflation (this is whole other topic, and one that you can’t control)
- This assumes the same diversified portfolio makes up the entire investment
The difference between starting at 20 and 40 is staggering!
- Starting at 20 makes you a millionaire at 54
- Starting at 30 take you ten more years at 64
- Starting at 40 you will not see the big M until 76
Getting to the million dollar mark is one thing, but real financial wealth is being able to continually withdraw funds without touching the principle so that it can generate more or less the same passive income for you the following year. With that in mind, see how different life could be if you don’t getting funding your IRA right away.
- Starting at 20 you will have a tax free passive income of over $100k at 58
- Starting at 30 you will have a tax free passive income of over $100k at 68
- Starting at 40 you wouldn’t crack $100k of passive income until 80