IRA Basics

IRA is an acronym for Individual Retirement Account. In general, there are two types of IRAs – Traditional and Roth. IRAs were created to help us save for retirement.  

A Traditional IRA helps you save for retirement in two ways. First, you may get an income tax deduction when you deposit money in the account. Second, there is no tax on the growth in the account. You pay tax only on the amounts you withdraw when you retire.

The major difference between a Traditional and Roth IRA is when the money is taxed. In a Roth IRA, you deposit after-tax money in the account, but you do not pay any tax when you withdraw the money.

The second key concept to understand is that an IRA is a type of account, not an investment on its own. To relieve some confusion, the IRS has recently started to refer to an IRA as an Individual Retirement Arrangement, instead of Account. Once you deposit money into an IRA, you will need to determine how to invest it. Within the IRA, you can put your money in Certificates of Deposit (CD), mutual funds, individual stocks or annuities.

Now for the fine print. While there are many details and complexities, the biggest issues for most people are do they get a tax deduction for their contribution and what if they need the money before they retire.

In government-speak, you must have “earned income” (a tax term that refers to wages and some other items) to contribute to an IRA. In other words, if you have a job, you can contribute.  The real limitations start now. For Traditional IRAs, if you have a retirement plan at work such as a 401(k) or a pension plan, you can still contribute to the account. However, you many not be able to take a tax deduction if your Adjusted Gross Income (AGI) is too high. For a Roth IRA, you can only make a contribution if your AGI is below a certain dollar amount. These limits change every year, so you can go to IRS Publication 590 to find the most current rules.  

The other piece of bad news is what happens if you need the money before you are age 59½. In a Traditional IRA, you not only pay income tax on the withdraws, the government adds a 10% penalty on top of the income tax. For a Roth IRA, only the 10% penalty is assessed since you already paid income tax on the money.

What Type of IRA Should You Use – A Roth IRA or A Traditional IRA?

The answer depends on good your crystal ball is. You need to guess if your tax rate be higher or lower in the future. Your answer is important because the accounts, at their core, are very similar. The major difference is that a Traditional IRA is tax-deferred, meaning that you pay no tax on your contribution today and no tax until you withdraw the money. When you do withdraw your money, it is taxed as earned income. A Roth IRA, on the other hand, is tax free, meaning that you put after-tax dollars in the account, but withdrawals are tax-free in the future.

Since no one knows the future, you can take one of three paths. You can hedge your bet, plan conservatively and hope for a better outcome or assume that nothing will change in the future.

If you decide to hedge your bet, you can save for retirement by putting some money in a Traditional IRA and some money in a Roth IRA. This way, no matter what happens in the future, you have optimized part of your holdings regardless of the final outcome.

Your second option is to plan conservatively and know that most likely you will end up better than you planned. Many people feel that taxes are lower now than they will be for many years to come regardless, of who is elected President in November. There are many reasons for this, such as a $10 trillion national debt and a Social Security system that is about to become a drain on the treasury.  If this is your chosen path, your best option is to use a Roth IRA. By paying taxes today when rates are low, you will have a lower lifetime tax bill.

Lastly, you can assume that taxes won’t change in the future. Typically, when people retire, their income is lower that it was during their working years. In this case, it makes sense to use a Traditional IRA. With this strategy, you get a tax deduction today and will pay taxes in the future at a lower rate than you would have paid today.

The most important thing to remember, no matter which strategy you choose, is that saving for your retirement and starting as early as possible is critical to have a successful retirement.

What are the Downsides of IRA's?

For all their good points, there are some downsides to IRAs, both Traditional and Roth IRAs. First, we will deal with a Traditional IRA. The major issues are limits on when you can take out the money, when you must take the money out and what happens when you die.

The IRS has set very strict limits on when you can take out your money and what happens if you don’t take your money out fast enough. Once you contribute to an IRA, you can’t touch the money until you 59 ½. There are some exceptions, but for the most part, if you do take the money out early you not only have to pay tax on the amount withdrawn, but a 10% penalty on top of it. For example, if you withdraw $10,000 from your IRA and you are in the 15% tax bracket, you will have to pay $1,500 in taxes (15% of $10,000), plus an additional $1,000 penalty, for a total tax of $2,500.

On the other side, you must start to take out the money in the year you turn 70 ½. This is referred to as the Required Minimum Distribution, or RMD. If you fail to take out enough, the IRS will penalize you 50% of the amount you did not withdraw. As an example, if your RMD was $20,000 and you only took out $12,000. You would need to pay a 50% penalty on the $8,000 you did not take out, or $4,000 (50% of $8,000).

When you die and give a non-IRA to your heir, the heir receives the amount in account free of taxes. However, with an IRA, your heir will owe taxes on the money in the account. Recent tax changes allow your heir to stretch the payments out over a long period of time, but taxes still must be paid on the withdrawals.

Now let’s turn to the Roth IRA. With a Roth IRA, you can take out money you contributed after the account has been open for 5 years. However, you can’t take out the earnings on the account until you are 59 ½. If you do take out the earnings, you need to pay a 10% penalty, just like in a Traditional IRA. Unlike a Traditional IRA, there is no required minimum distribution, so you won’t need to take out money in your retirement if you don’t need it. Since money in the account is already tax free, your heirs will not owe taxes on it when you die.