Understanding the Complex World of IRAs
Regardless of how you feel about the U.S. government, it does provide several excellent opportunities to reduce your tax burden while saving for retirement. Unfortunately, the feds can’t help but make it as complicated as possible.
With a laundry list of investment accounts, such as the 401(k), 403(b), and the 457(b), all of which come with their own specific rules and regulations, it’s easy to get lost in a lawyer’s fantasy land of obscure acronyms and seemingly random three-digit numbers.
However, with the possible exception of the 401(k), there is no retirement account that’s received more attention than the individual retirement account, better known as the IRA. The IRA was designed to be an easy-to-understand investment vehicle through which workers can supplement retirement savings from other accounts, such as a defined-benefit pension plan.
The traditional IRA operates much like a 401(k). Contributions can be deducted from your income, providing a significant upfront tax benefit for wealthier individuals who are in a high tax bracket. In addition, IRA investments grow tax-deferred (no capital gains, dividend income, or interest income is taxed) which significantly improves your overall investment returns.
Of course, the government isn’t going to let you get away completely scot-free – eventually everyone has to pay Uncle Sam! When you withdraw money from an IRA account, you’ll be required to pay income taxes on it. In order to ensure that Uncle Sam gets his share, the government mandates that anyone with an IRA must begin withdrawing money from it by age 70.5. This is known as a required minimum distribution.
Although a traditional IRA definitely beats investing in a taxable account, it may not be suitable for every investor. For instance, low-income workers are not likely to benefit much from the immediate tax deduction for an IRA contribution. In addition, investors may not want to tie up their money for such significant lengths of time. If you withdraw any funds from a traditional IRA before the age of 59.5, you’ll be subject to a 10% tax penalty, in addition to ordinary income taxes.
To help obviate some of these shortcomings – and to further muddle the entire retirement investment landscape – the government introduced the Roth IRA, which comes with its own unique blend of costs and benefits. Unlike traditional IRAs, Roth IRAs don’t come with any immediate tax benefit; contributions are made with after-tax money. However, money in an IRA is not subject to any further taxation once the contribution is made, even after it is withdrawn from the account.
The tax-free nature of a Roth IRA has made it a very popular option with investors. If you expect your income tax obligations will rise as you get older, it makes sense to pay your taxes upfront. Similarly, Roth IRA contributions act as a hedge against future tax increases, a serious possibility given the state of the government’s current budget deficit and its future liabilities.
In addition, because income taxes have already been paid on Roth IRA contributions, Roth IRAs tend to be both simpler and more flexible than traditional IRAs. For instance, there are no required minimum distributions, which gives you far more flexibility in depleting your various investment accounts during retirement. Even better, contributions to a Roth IRA can be withdrawn at any time without penalty, leading some people to use that money as a secondary emergency fund.
The decision between a traditional and a Roth IRA is not a simple one. However, as a general rule, it is safe to conclude that people in higher tax brackets are more likely to benefit from the immediate tax deduction of a traditional IRA, while low-income investors would be better served paying their taxes immediately.
Of course, you could always hedge your bets by contributing to both accounts. Although you can only contribute $5,000 per year into an IRA, you are free to divide that money between the two accounts in any way you wish. Regardless, both accounts provide great tax benefits for people looking to save for retirement and should be considered by all conscientious investors.
If you need assistance choosing the right IRA for you, Pathway Financial Planning has specialized knowledge about both types of accounts, and we can provide an individualized recommendation based on your unique financial circumstances.
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