Saturday, November 12, 2011

The Individual Retirement Account

The Individual Retirement Account (IRA) is a general term for retirement plans that give tax advantages for retirement savings.  I posted a very funny and educational video about it in September but I haven't really said much about ways to save for retirement other than the 401k.  So here I will talk about the two most common IRAs: traditional IRAs and Roth IRAs.

Most people have trouble choosing between the two; some even end up opening both.  IRAs were implemented to help citizens pay for their retirement with the main attraction being tax savings.  People who needed incentives to save were given these potential savings through IRAs.  Traditional IRAs help save you current taxes while Roth IRAs help save future taxes.

First, what is an IRA?  It is essentially an account where you can contribute money up to a limit each year and get tax savings.  Aside from the tax savings and contribution limit, it looks like a normal brokerage account.  You can make investments and buy stocks and bonds.  These types of accounts are also offered at most brokers as well and are definitely something to take advantage of as early as you can.  For both IRAs, the current contribution limit is the lower of $5000 or your taxable compensation for the year.  If you contribute an excess amount to your IRA, the excess amount will have to be withdrawn by the date your filing is due or else you will be charged a 6% excise tax.

Traditional IRAs help you save on your current taxes.  Whatever you contribute to your traditional IRA is deducted from the amount of income you will have to pay taxes on.  For example, let's say you earned $10,000 this year.  If you contribute $5000 to your traditional IRA, you will save taxes on that $5000.  You can invest the money you put into the account, and any interest, dividends, or capital gains earned on the account are not taxed.  However, everything is taxed when you withdraw money after becoming eligible at age 59.5 years of age (and it is mandatory to begin distributing money out of this account when you hit 70.5).  The main benefits of the traditional IRA is that you save taxes now.  The idea is that when you retire, you will be in a much lower tax bracket than currently so you will save the difference in taxes.  You also save the difference in taxes on any earnings you make in your account (i.e. interest that would have been taxed during your working years would be taxed at a lower rate when you withdraw the money when you retire).  If you withdraw before you are 59.5, you will have to pay taxes on your withdrawal along with a 10% penalty.

In contrast, a Roth IRA is an account where you contribute after-tax income but there are no taxes taken when you withdraw money from the account.  The contribution limit assumes you earn below $120,000 if you are filing as a single (otherwise, you are not allowed to contribute to a Roth).  The other filing types have different requirements that I won't go into specific detail.  Additionally, like the traditional IRA, any interest, dividends, or capital gains do not get taxed on the account, but unlike the traditional IRA, the earnings do not get taxed even when withdrawn.  Although you cannot save taxes on your income, your money can grow completely tax-free.  Withdrawals do have to be a qualified distribution, however, and comply with these general guidelines: the taxpayer must have had the account open for at least five years and the taxpayer is 59.5 years old.  If these guidelines do not apply, there are some exceptions for qualified distributions including if the taxpayer is disabled, using the withdrawal to purchase his or her first home (up to $10,000 limit), or deceased (the beneficiary will collect the money).  Also, only earnings on the contributions have to stay in the Roth IRA account.  From the IRA website, "You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA" which means if you deposit money into your Roth IRA, you can withdraw it at anytime without having to pay any penalty (and you already paid taxes on that money so it won't get taxed again).  Any non-qualified distributions of earnings in your Roth IRA, however, will face a 10% penalty fee.

So what are the main advantages for each?  If you think you will be in a lower tax bracket when you retire or want to get the immediate tax break, a Traditional IRA may be right for you.  If you can forgo the immediate tax break, a Roth IRA has higher potential for tax savings since all your earnings continue to grow tax-free.  This is especially beneficial if you believe tax rates will rise in the future as well (and this would diminish the effect of tax savings in a Traditional IRA).  The power of compounding will work wonders on a Roth IRA.  Also, if you have a higher disposable income, a Roth IRA has a higher "effective" contribution limit in a sense since you are contributing after-tax income rather than pre-tax income.  For a Roth, you also aren't forced to withdraw distributions at 70.5 which allows you to  keep your money in your Roth for a longer period of time and pass it on to someone else if you wish.  On top of all this, you can withdraw your contributions if you wish without penalty (but any earnings gained in the account must stay their until you are of age to make a qualified withdrawal).

You can probably tell that I am a bit biased toward Roth IRAs.  There is some risk that Congress may change the rules on Roth IRA withdrawals before you can realize the tax benefits and you may not recognize many tax benefits regardless if you pass away before reaching retirement age or shortly afterward.  Also, you may be below the tax threshold after retirement which would mean that a traditional IRA would have been a better choice.  Overall though, I believe a Roth IRA is a great retirement tax tool and young adults should open one early on to realize the full benefits of such an account.  This post was very long and perhaps a bit convoluted so I may post something simpler later summarizing the main points.

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