Since their inception in 1974, Individual Retirement Accounts, or IRAs, have become wildly popular. About 40 million US households, or 32%, owned at least one type of IRA as of mid-2015. By the end of that year, IRA assets totaled $7.3 trillion, which was about 31% of US retirement assets1.
People like IRAs because they can be invested in just about everything except life insurance or collectibles, so it is simple to make a profitable return on your money. Investors with experience in real estate can even use their wealth to buy real estate through a self-directed IRA.
Unlike employer-sponsored retirement plans, an IRA allows you to be the full owner and your plan is in no way tied to your employment. You can even withdraw funds penalty-free before age 59 ½ if it is for a qualified first-time home purchase or education expenses.
For many people, investing in an IRA is a straightforward decision. The areas they struggle with is in knowing if they are eligible for one, and in deciding whether to invest in a traditional or Roth IRA.
Benefits of Investing in a Traditional IRA
Prior to 1997, there was only one kind of IRA available to investors. This type of IRA is now referred to as a traditional IRA, which is a tax-deferred retirement account. This means that it is funded with pre-tax money and the taxes are paid when the money is withdrawn in retirement. This is a great benefit because you have more money available to invest if you don’t have to pay taxes on it beforehand. Additionally, many people find themselves in lower tax brackets in retirement, resulting in lower taxes paid overall.
Benefits Of Investing In A Roth IRA
Out of the Taxpayer Relief Act of 1997 a new kind of IRA was born, named after Senator William Roth of Delaware, who was the chief legislative sponsor of the act. Roth IRAs differ from traditional ones in a few key ways. The most significant difference is the tax treatment. When you contribute to a Roth you pay all taxes up front, whereas traditional IRAs are tax-deferred. What makes Roths so popular, though, is that you don’t have to pay taxes on any of the growth. Everything generated by compounding interest stays in your pocket.
Roths also differ from traditional IRAs in that there are no required minimum distributions. So, you can leave your money in the account to grow for perpetuity, instead of being required to start taking withdrawals (and stop contributions) at age 70 ½ like with a traditional account. Roth IRA distributions are tax free if made 5 years after the initial contribution to the plan and you are over 59 1/2.
Some people even utilize this aspect of Roth IRAs as a way to provide tax-free income for their grandchildren and future generations. In addition to the traditional IRA’s allowances for special withdrawals, contributions (not growth) can be taken out at any time for any reason without penalty.
There are income limitations on who is allowed to use a Roth IRA. In 2016, singles making over $132,000 cannot contribute to a Roth and the amount they can contribute begins phasing out after $117,000 of earnings. The phase-out period for married tax filers is $184,000-$194,000. However, anyone can convert a traditional IRA into a Roth through a “backdoor conversion.2”
Which IRA Is Better For You?
Considering the differing tax treatment, a Roth IRA is almost always better for younger people who have more time to save and, therefore, take advantage of compounding interest. If you are nearing retirement and will need the money early in retirement, you may be better off with a traditional IRA. Many people choose a Roth regardless of their age so that they won’t be required to take distributions and they can leave the money to their families. If you make too much money to be eligible for a tax deduction for a traditional IRA you are better off with a Roth, though you will have to use a “backdoor conversion” to open one.
If you are rolling over an old 401(k) to open your IRA, your decision regarding the type of account to open will have considerable tax implications. You won’t have to pay any taxes to roll a traditional 401(k) into a traditional IRA, but to roll it into a Roth you will be required to pay taxes on the entire amount. For this reason, in 2012, 87% of new traditional IRA accounts were opened by rollovers as opposed to only 11% of Roth accounts3.
Are you Eligible to Contribute to an IRA?
Many people think they aren't eligible to contribute to an IRA. But if you or your spouse earn taxable income and are under age 70 ½, you can contribute. It's as easy as that. However, whether your contributions are tax deductible depends on your income and whether you have access to a work-related retirement account. Here are the guidelines for 2016:
- If you do not have a retirement plan at work and you are younger than 70 ½, you can put money in (up to the annual contribution limit) and deduct the entire amount from your taxes. (If your spouse doesn't work outside the home, he or she can also invest up to the federal limit and deduct the full amount).
- If you happen to have a 401(k) or other retirement plan at work, your contribution is fully deductible only if your adjusted gross income (AGI) is less than $98,000 for a married couple filing jointly or $61,000 for an individual.
- If you have a workplace retirement plan, the deduction for your traditional IRA contribution is phased out completely if your AGI is $118,000 or more (married couple filing jointly) or $71,000 or more (individual), or $10,000 for a married person filing separately.
- If you are not covered by a workplace plan but your spouse is, your contribution is fully deductible if your combined income is less than $184,000 and becomes phased out at $194,000 or more.
The best kind of IRA account for you depends on your unique situation and preferences, but most people are eligible to open one. When making important financial decisions such as this one, it is always wise to talk to an experienced professional who can help you understand your options and the implications of the different options available. If you are considering investing in an IRA, give me a call at (505) 369-1224 or email me at kbrown@gfainvestments.comand I can answer your questions and help you decide what the best move is for your particular situation.
About Kevin Brown
Kevin Brown is an independent financial advisor serving individuals and families in New Mexico. It is his goal to give unbiased recommendations and impartial guidance based on every client’s individual and unique needs and goals. Kevin enjoys helping people to feel confident in their financial future by developing a plan to help insure against what can go wrong so they can enjoy the luxury of investing for what can go right! Call his office today at (505) 369-1224 or email kbrown@gfainvestments.com.
__________
1 https://www.ici.org/pdf/per22-01.pdf
2 https://investor.vanguard.com/ira/roth-ira-income-limits
3 http://www.icifactbook.org/fb_ch7.html#individual