An IRA is an Individual Retirement Account. The benefits are similar to a 401k but I won’t be talking about a 401k today. My recommendation is usually to have both though.
Many have heard of and/or are using this vehicle already to facilitate their retirement goals. However, there are two types that can mean drastic differences to your retirement savings.
A Few Facts about IRA’s:
- You can contribute up to $5500 for 2013 ($6500 if you’re 50 or older)
- You have until April 15 to contribute to your IRA limits for the previous year
- You can begin withdrawals without penalty after 5 years if you reach age 59 1/2 or meet other qualifying conditions.
- Contributions are made after-tax
- Your modified AGI income must be below $127,000 ($188,000 if you file jointly) for 2013
- Principal contributions can be withdrawn penalty free any time
- Contributions are made pre-tax
- Your modified AGI income must be below $69,000 ($115,000 if you file jointly) for 2013
- Generally, if you are under 59½, you must pay an additional 10% tax on the distribution of assets
The main difference is the tax advantages. If you contribute to a traditional Roth, you can deduct your contributions pre-tax, meaning you won’t pay any taxes on that earned income that year. However, with a Roth IRA, your contributions are made after taxes and are known as the IRA Basis (you can look here if you find yourself asking what is a basis in an ira). There is no immediate tax benefit with a Roth, however you pay no taxes when you take your withdrawals in retirement.
If you believe that the tax rate applicable to your withdrawals at retirement will be more than they were when you contributed, then a Roth IRA might be for you.
Assume you purchased $5500 worth of KO and in 20 years those shares are now worth over $20,000 (A 7% annualized gain would give you $21,283.26). Well if you held this money in a Roth IRA, you wouldn’t pay any taxes on these gains. If you held the stock in a traditional IRA, you’d owe taxes on over $14,500 of capital gains and dividends.
Let’s assume you have $5500 pretax to be able to put into a Roth or Traditional each year. Well you can either contribute this full $5500 to a traditional IRA or after taxes (assuming 25%) , you will have $4,125.00 yearly to invest in a Roth.
Here’s a look at the growth of your accounts for 20 years assuming a 7% simple annual interest rate and contributions at the end of each year.
Let’s say you want to start taking distribution after the 20 years are up. Well you owe taxes on the entire amount in your Traditional IRA so you pay taxes with each distribution. Without further growth you’d owe $56,368.80. If you subtract this from $225,475.21 then you have exactly $169,106.41, which is the same as the value in your Roth.
So if you started in a 25% bracket and end up still in your 25% bracket then your earnings are pretty much the same.
Will saving taxes today be worth less than savings taxes on a larger amount in the future? It really depends on your timeline and estimated tax brackets.
If you have 30 years until retirement, that’s a lot of time for your investments to compound and grow. If you have a shorter timeline to retirement then you don’t have nearly as much time for compounding to work its magic.
It can be very difficult to estimate your tax bracket in retirement. Between your income level and the government changing the rules, anything could happen in the future.
If you are in a smaller tax bracket at retirement then you might be better off with a traditional IRA. Conversely, if you are in a larger tax bracket at retirement then you would probably be better off in a Roth IRA.
Regardless of your tax brackets, my recommendation is to start saving and start investing for your future now!
Personally, I don’t meet the income levels but I’d probably be contributing to a Roth if I did.
You can find a lot of additional information on the IRS website here.