IRA’s, or Individual Retirement Accounts, are good avenues to invest your money for the long-haul, and come with a number of advantages. They’re similar to employer-sponsored 401(k)’s in a way, but are totally decoupled from an employer; hence the I in IRA. Just like a 401(k), the money you put into these retirement accounts is what some people refer to as “tax advantaged” – meaning that your tax liability goes down as a result of using them, depending on the flavor. Just like 401(k)’s, they come in two primary flavors: traditional and Roth.
Some people have IRA’s, but only 32% actually have an IRA, and the number that actively contribute to theirs is even less. This is based on research a couple years old, admittedly, but even so it’s a bit disheartening. If you learn nothing else today, hopefully at least you know that there’s something else out there for you to invest in and make sure you’re set up for a successful life later.
A Brief Overview
IRA’s were created back in 1974 as a way to allow individuals to save for their own retirement. Obviously at the time pensions were more popular than they are today, but aside from that, there weren’t many good vehicles to use to save for one’s retirement; the 401(k) didn’t come around until 4 years later. The idea behind the IRA is pretty straight forward, and so are the two “flavors” (traditional and Roth). Both types of IRA’s let you contribute up to $5500 (with an extra $1000 if you’re over 50) each year and generally have a better selection of things to invest in over your typical 401(k) plan. They both let you take out money if you need it for a down payment or medical expenses (with some potential tax implications and limitations), but that’s about where the similarities end. So, what’s the difference?
Traditional IRA’s are retirement accounts that you can contribute pre-tax dollars to; doing so (maybe) reduces your tax liability for the current year. I say maybe because as your income grows, your ability to deduct these contributions may phase out (depending on if you have a retirement plan offered through your work). Still, this can be a pretty sweet deal; your earnings will grow, tax-deferred, until you decide to take money out.
You can take money out at any time once you hit 59.5 (I thought half birthdays only mattered to seven-year, or rather seven-and-a-half year olds? I guess not!). When you do, you’ll pay taxes on that money you take out since you did not pay them when you contributed. The bad news? If you don’t want or need to take the money out, it sucks to be you: the government forces you to take (and thus pay taxes on) withdrawals starting at age 70.5. If you have a ton of passive income in retirement and wish to pass your fortune down to your heirs, this will be slowly chipped away forcibly by the government. Of course there are ways you can deal with that like gifting (currently you can gift a single person up to $14,000 annually without any tax implications), but it’s a ding against a Traditional IRA.
Below I’ll talk about a Roth IRA, but just a quick note on eligibility; even though you may not be able to directly contribute to a Roth IRA due to your income, you can always contribute to a Traditional IRA…you just might not get the tax break. One strategy some people employ if they fall into this camp is to contribute to a Traditional IRA and then convert it into a Roth; doing so is kind of a “back door” into a Roth when you may otherwise be ineligible to contribute. If you go this route, I’d recommend talking to a professional who can help assist this this process and make sure you don’t get dinged on taxes accidentally.
Main Advantages: Tax-deferred growth, and everybody can contribute to one regardless of income.
Main Disadvantages: Taxes when you withdraw money, and forced withdraw rates once you hit 70.5. Depending on your income, you may not get a tax break now.
Before we dive into how Roth’s work, here’s another brief history lesson: William Roth was a Senator in Delaware who, in the late 90’s, successfully pitched the idea for this type of IRA, hence the name. Relative to the Traditional IRA, the Roth variant is, therefore, somewhat of the new kid on the block. History lesson finished.
Roth IRA’s flip the taxation on its head. Instead of being taxed when you withdraw money, Roth IRA’s are taxed when you contribute the funds. When you withdraw those funds, you aren’t taxed (since you’ve already paid the tax on that money). This gives a big advantage to your retirement life, at the expense of potentially having a smaller nest-egg; if you can’t afford to max with after-tax dollars, it’ll be easier to use pre-tax dollars in a Traditional IRA and then use the tax break money to invest. The caveat to this, however, is that for the math to work you need to invest that tax break money, which takes discipline that many people frankly don’t have . If you don’t have to worry about paying that money back to Uncle Sam, you simply won’t need as much of a nest egg anyway.
If you happen to earn money that you don’t need to spend later in life, you can also continue contributing to your Roth IRA until the day you die, should you so choose. This is pretty cool for folks who have other passive income – like real estate or dividends or other investments – that easily pay for their retirement, as it allows you to pass all of this money down to your heirs without it being slowly chipped away by forced withdrawals.
If you think you’ll be in a higher tax bracket at retirement, a Roth may be a better option as well. If you’re paying 15% now but expect to be paying more when you’re older (for various reasons), it makes sense to pay that tax now. But, the future isn’t set in stone; taxes rates can change a bit, and costs will likely continue to increase as you age, requiring a potentially higher distribution. This leaves a bit of room for speculation, making the decision a little less clear.
Main Advantages: Withdrawals are not taxed like they would be in a Traditional IRA, and you’re not forced to take withdrawals.
Main Disadvantages: Initial amount is taxed, so if you couldn’t otherwise max it without the tax break, you’re growing your money on ‘less’. Also, if you are a high earner, you may not be eligible for one.
So, which one?
The general advice you tend to see is that if you think you’ll be in a higher tax bracket when you retire, you should contribute to a Roth. If you’ll be in a lower tax bracket (which many folks could be, simply because they aren’t planning on having some expenses, like a mortgage, so they can live off less), then go for a Traditional. But it’s not that cut and dry.
For starters, if you’re earning too much money to take advantage of the up-front tax benefits of a Traditional IRA, it loses some of its appeal. But at a certain point, a Traditional may be your only option of the two.
If you can max out your contributions either way, a Roth may give you more, assuming the same rate of return; simply because when you take the money out, you won’t pay taxes on it. Most people, quite frankly, don’t have the discipline or systems set up to invest the money that you’d get as a tax-break at the end of the year with a Traditional, which is a primary reason I’d argue for a Roth instead if you can.
At the end of the day, if you’re maxing either a Traditional or a Roth IRA, you’re in a much better position than at least 72% of Americans who aren’t actively contributing to one at all.
Do you have a Roth or a Traditional IRA as part of your retirement plan?
As an aside, I just want to remind everybody that I’m not a Certified Financial Planner, nor do I claim to be providing expert advice. If you’re unsure what you should do, I’d recommend working with a CFP or Accountant who can help you weigh the pros and cons for your specific situation.