I’ve had a few questions flow through my inbox asking me to clarify some of the more fundamental aspects of retirement planning/saving. As a result, I’ve been working on a few posts that I hope will function as a sort of knowledge base. I know what it’s like to look at your bank account with the desire to do something, anything, to help with retirement but without possessing the knowledge to take action. I was in that boat in 2007 when I opened my first IRA and bought what in retrospect was the most random assortment of securities imaginable.
Individual Retirement Arrangement
…a form of “individual retirement plan”, provided by many financial institutions, that provides tax advantages for retirement savings in the United States. An individual retirement account is a type of “individual retirement arrangement” as described in IRS Publication 590, Individual Retirement Arrangements (IRAs).
In plain English, an IRA is a retirement account that you can put money into where that money can grow in a tax advantaged manner. Money that you put into an IRA is called a contribution. Money that you take out of an IRA is called a distribution. You are limited in the amount you can contribute to an IRA each year by the IRA; in 2013 the amount an individual can contribute to an IRA is $5,500, if you are over 55 in age you are allowed to contribute $1,000 more. The IRS calls this extra $1000 a “catch up” contribution since people over 55 are closer to retirement. The defining difference between a 401k and an IRA is that you are solely responsible for opening, funding, and managing an IRA.
Types of IRAs
I see a lot of confusion regarding the different types of IRAs, there are two main types and a less used third type.
- A Traditional IRA is an IRA that is funded with effective pretax dollars. This means that you will not pay income tax on the money that you contribute to a Traditional IRA. Since you contribute to the IRA with the money in your bank account that you’ve already paid income tax on, you claim a deduction for this money on your income tax return at the end of the year. This sounds more complicated than it is, your broker will send you a Form 8606 at tax time that clearly indicates how much money you have contributed and need to claim a deduction on. All the major tax preparation software will explicitly ask you if you have a Form 8606. You’re not home free though, when you withdraw money from the IRA in retirement you will pay income tax on the distributions.
- A Roth IRA is an IRA that is funded with post tax dollars. This means that you’ve already paid income tax on the contributions to a Roth IRA. And, since the money going into the account has been taxed, you are not required to pay tax on the distributions from a Roth IRA. This is, in my opinion, a remarkable deal. You pay absolutely no tax on your distributions.
- A SIMPLE (Savings Incentive Match PLan for Employees) IRA is an IRA that is functionally identical to a Traditional IRA but differs in the contribution limits. It is most commonly used by self-employeed people and very small companies that do not have a full employer sponsored retirement (401k) plan. For the purposes of the rest of this article I am going to lump the SIMPLE IRAs in with the Traditional IRAs since the two account types as functionally identical.
Which is Best?
Logically, the next question most people ask relates to which account is best. This is a difficult question to answer because there isn’t a correct answer, each account has its advantages and the significance of those advantages will vary between investors. Generally this discussion can be summarized into two main ideas.
- Income Level - Since traditional IRAs allow one to pay less income tax now, it follows that the higher your income (and therefore the higher your effective tax rate) the larger the benefit one will realize by paying less income tax now. The general idea behind this is that most people will have a very small income in retirement (and therefore be subject to lower income tax rates). It’s optimal to pay tax on your IRA distributions then, instead of when you made the contributions and were exposed to the higher tax rates. As such, people subject to the higher marginal tax rates tend to favor Traditional IRAs while people in the lower marginal tax rates tend to favor Roth IRAs.
- Your Opinion on the Future of US Tax Law - This is the trickier of the two ideas and the one that is completely subjective. If you think that tax rates are likely to get lower in the future than they are today, it would make sense to contribute to a Traditional IRA. This will allow you to wait to pay taxes until retirement, when you think taxes in general will be lower. The inverse is also true. If you think that tax rates are likely to get higher than they are today, it would makes sense to contribute to a Roth IRA. This will allow you to pay those taxes now instead of in retirement when you think taxes in general will be higher.
What I think?
I’d be lying if I said I hadn’t spent significant time modeling various tax and market performance scenarios in an attempt to determine which IRA type was really and truly “better.” I wouldn’t be lying, though, if I told you that all that work didn’t give me a clear answer. In the face of my inconclusive quantitative approach, I do have an opinion based on a qualitative approach.
If you look at the US income tax rates we face today and put them in a historical context, you’ll notice that we’re paying a less amount of income tax than we have ever paid in the history of the country. Regardless of how you feel about taxes politically, it is an objective fact that, except for a period of 5 years during the “roaring” 1920s, American income tax rates are the lowest they have ever been. Take a look at the figure below.
With this in mind, I personally primarily contribute to a Roth IRA. I believe that tax rates have no where to go but up at this point. We’re probably headed to something closer to the rates we saw in the late 1960s and 1970s (or at the very least levels similar to the 1980s) for the next several decades. However, I do hedge against the uncertainty of my future tax rate by also contributing to a Traditional IRA. The ratio of my Roth to Traditional contributions is about 3:1. For every $3 I put into a Roth IRA, I put $1 into a Traditional IRA.
How Do You Open an IRA?
I decided to break this off into a separate post so that I could include a level of detail that only an engineer will appreciate. Check it out here, How to Open an IRA.
What Should I Invest In?
Alright, so ideally you’ve got your brand new Traditional or Roth IRA set up, now what? Now you need to contribute money to the account via your broker and buy assets. The process of contributing money to an IRA is simple and identical to transferring money between electronic bank accounts. It can typically be done online or over the phone with a call to your broker.
The most difficult decision now is what to invest in within your IRA. An IRA, by it’s nature, allows you to invest in anything you want. This discussion is outside the scope of this article. I do hope to put together a post about my personal strategy, but for now I will refer you to one of my favorite websites, the](http://www.bogleheads.org/wiki/Three-fund_portfolio#Choosing_your_asset_allocation) on the Bogleheads website. Briefly, the three fund portfolio aims to hold broadly diversified index funds in the three major asset classes: US stocks, International stocks, and Bonds. By investing in this manner you are instantly diversified across thousands of different securities, will never significantly underperform the market, and are mathematically certain to outperform most investors doing differently.
- How much money should I put into my Traditional/Roth IRA?
- You should contribute the maximum allowed each year, in 2013 that amount is $5,500 (plus another $1,000 is you are over 55 years of age.
- You mentioned that you personally “primarily contribute to a Roth IRA.” Does this mean that you contribute to a Traditional IRA too, can you do that?
- Yes, you are allowed to contribute to either a Traditional IRA, a Roth IRA, or a combination of both. As long as your total contributions across all IRAs are less than the IRS specified maximum contribution limit, you’re good. You could contribute $1 across 5,500 different Traditional and Roth IRAs, the IRS won’t care. Note, please don’t open 5,500 IRAs.
- What if I exceed the IRS contribution limits?
- Don’t do this, you’ll have to pay a fine. Usually you can withdraw money from the IRA before tax time and be alright. Contact your brokerage for specific information.
- What if my car breaks down and I need the money in my IRA for car repairs?
- Generally you want to avoid removing money early from your IRA at all cost. This is called taking an early distribution. Early distributions are heavily penalized by the IRS (10%) and you’re never allowed to replace that money (it isn’t considered a loan). That said, it is possible to remove contributions to a Roth IRA, I even discuss doing so in a post about making an Early Withdrawal from Roth IRA accounts. Please take note that YOU SHOULD NEVER TAKE EARLY DISTRIBUTIONS FROM YOUR IRAs unless it is an extreme circumstance (or you retired early).
- Are IRAs really worth it?
- Yes, completely. The US government is giving you a method to avoid a significant tax bill. Use it.
- That are lot’s of other things I could be doing with my money, should I do X or should I fund an IRA?
- Generally I advise people to make saving for retirement a priority. Obviously this is a personal decision, but making IRA contributions should be factored into the family budget and happen along side general debt payment, mortgage payment, and all the other things that constantly seem like they need our financial attention. A monthly contribution to your IRA as small as $25/month each month can end up being as much as $28,340 in 30 years assuming average historical market returns. Can Retired You afford not to contribute to an IRA right now?
- I work but my husband doesn’t, can he contribute to his own IRA too?
- As long as you file income taxes jointly and have more than $11,000 in earned income, yes he can.
- If I contribute to an IRA can I still contribute to a 401k? What if both the IRA and the 401k are “Roth”?
- Yes, no worries. The IRS lets you contribute to both account types regardless of if they are Traditional or Roth.
- I just tried to open an IRA and the brokerage said I didn’t qualify, what gives?
- There are income limits for both Traditional and Roth IRAs. If you’re single and make more than $127,000 you can’t contribute to a Roth IRA. See the](https://www.fidelity.com/retirement-ira/ira/contribution-limits-deadlines) for more information including the income cutoffs if you are married. Technically you can always contribute to a Traditional IRA, but you can’t take the deduction for your contributions once you make more than $69,000.
- Where should I open my IRA?
- I briefly cover this in my post How to Open an IRA, but I recommend Vanguard to people. Vanguard was the single brokerage to first and most completely embrace the low cost mutual fund. Do a Google search on Jack Bogle and read a bit if you have some time. The man was probably one of the most empathetic finance CEOs in the history of the world. He cared about helping the average Joe as much as he cared about making money.
I hope that this article was helpful without being too simple. It can be difficult to explain material like this to such a diverse audience. If you have any questions, please don’t hesitate to leave a comment or send me an email. I’ll help however I can. And if you found this article helpful, please let me know that too!comments powered by Disqus