So, what is an IRA?
If you’re like me, you likely have no idea what an IRA is beyond “a retirement thing”. For some reason, the Finance industry likes to make itself appear complicated, giving everything an acronym. Being married to a finance guy, I get to ask questions about this stuff and then share the info with all of you! So today we’re going to break down all of the confusion around what IRAs are and how you can use different types to help you reach financial independence.
Here is what we’ll cover:
- What are Individual Retirement Accounts?
- What are the different types of IRA accounts?
- Where/how can you open one?
- Most importantly: how can IRAs make you rich?
Let’s get started!
Getting Started With IRAs
So what IS an Individual Retirement Account? IRA’s are a special tax treatment of an account that allows you certain special privileges. This includes perks like a deduction on your current tax bill, deferred growth on your interest, and ability to pay taxes when you start drawing income on the IRA during your retirement years.
Simply put, IRA accounts tend to be tax-advantaged investment accounts that you can sock your money into.
But for every gimme, there is a gotcha. To take advantage of these fantastic tax benefits, there is typically a maximum contribution limit on how much you can put into your IRA each year. Also, there is a cap on how much you can earn to use the investment vehicle. When you invest in certain types of IRAs, you can potentially get a tax deduction.
On top of that, a specific IRA allows you to withdraw your principal and your earnings completely tax-free so long as you meet specific criteria! How amazing is that?
Are you seeing how this could be pretty helpful?
If your plan is long-term investing, the advantages to an IRA are tremendous. They are called retirement plans for a reason. This helps offset your income in retirement if social security either no longer exists or doesn’t cover the payment you need to maintain your lifestyle.
Here are a couple of things to remember.
- These accounts are supposed to be used for retirement
- They typically come with an income cap to be able to invest in them
- If you take an early distribution from an IRA, it usually comes with a penalty of 10% (there are ways around this)
- There is a max that you can deposit each year into an individual retirement account
Now that we’ve taken the time to explain what an IRA actually is, let us figure out the different types and what might be most beneficial to you!
Traditional IRA
One of the most common that you will hear about is a Traditional Individual Retirement Account or a Traditional IRA. This was created in 1974. This was to help individuals like you and me set aside funds for when we actually retire and no longer receive a paycheck. To incentivize people to do this, they gave you some pretty excellent tax benefits!
For every dollar you invest in a Traditional IRA, you can deduct a dollar from your taxes. So, if you were to invest $5,000 this year and you made $50,000 for the year, your new reportable income is $45,000.
The other cool thing about the Traditional IRA is that it is also considered ‘above the line.’ So it doesn’t matter if you file a standard deduction or itemize at the end of the year. You can still deduct the total amount from your taxes.
| Years | Starting Balance | Interest | Ending Balance |
|---|---|---|---|
| 1 | $100,000 | $7,999.99 | $108,000 |
| 2 | $108,000 | $8,640.01 | $116,640 |
| 3 | $116,640 | $9,331.19 | $125,971.20 |
| 4 | $125,971.20 | $10,077.70 | $136,048.90 |
| 5 | $136,048.90 | $10,883.91 | $146,932.81 |
| 26 | $684,847.52 | $54,787,79 | $739,635.32 |
| 27 | $739,635.32 | $59,170.83 | $798,806.15 |
| 28 | $798,806.15 | $63,904.48 | $862,710.64 |
| 29 | $862,710.64 | $69,016.85 | $931,727.49 |
| 30 | $931,727.49 | $74,538.19 | $1,006,265.69 |
Remember the gimme gotcha comment? If you’re single and you make over $75,000, you cannot take a tax deduction on your investment.
The rules are a little more forgiving for married couples, and it also depends on if you both have a retirement plan at work. If you both have retirement plans, then as a couple, there is no deduction if you make over $124,000. If one of you does not a have retirement plan, then you can go up to $206,000.
This is the part where I need to tell you to speak with your own tax consultant to understand your specific situation and see if you can deduct your contribution.
The nice thing about this is that you have until April 15th of the following year to make your contribution. Be careful though – If you make a contribution before April 15th for a previous year you need to specify that the contribution was actually for that previous year to report it correctly.
Roth IRA
Now we move on to my favorite type of Individual Retirement Account, the Roth IRA. This was first created in 1997 by Senator William Roth, a staunch advocate for tax cuts, and was set up to help the individual investor like you or me.
With a traditional IRA, you deduct the contribution from your income tax and pay taxes later when you take a distribution. The remarkable thing about a Roth IRA is that you pay taxes up front and get a tax-free withdrawal!
Now I know what you’re thinking – isn’t it better to get a tax break up front with the Traditional IRA? To better understand why a Roth IRA can be so great, let’s walk through a scenario. I ran a quick breakdown on Dave Ramsey’s Investment Calculator. (This is just for rough numbers.)
- At 30 years old you start with $6,000 in your IRA
- You add $500 a month to your IRA until you reach the age of 67
- You earned an average return of 8%.
- You retire with roughly $1.2 million in your IRA.
Now here’s the fun part: let’s consider this under 2 lenses and see what looks different!
First let’s pretend you invested this money in a Traditional IRA
Ok so you invested your money above into a Traditional IRA. When you access any portion of it in retirement, the proceeds are paid out as ordinary (read: TAXABLE) income. This means if you take out $50,000 annually to live on during your retirement, and you receive $30,000 in social security, your highest tiered tax bracket (as of today – and you can assume that will be much higher years from now when it matters to you) would be 22%. You would pay roughly $13,450 in just Federal income tax. Every year. If you take more out, you pay more. If you live another 30 years into retirement, that is over $400,000 in taxes you’re paying.
Second, let’s pretend you invested this money in a Roth IRA
Ok so you invested your money in the above scenario in a Roth IRA. You’ve reached retirement age and you decide to take out $50,000 annually to live on and you receive $30,000 in social security. You pay ZERO income taxes on the money you withdraw from the Roth IRA. The only income taxes you pay will be on the social security you receive, putting you in almost the lowest tiered tax bracket, 12%. You would pay 12% on the $30,000 of social security you receive, totaling $3,600 in Federal income tax per year. (A significant savings compared to the $13,450 you paid per year when you invested your funds in the Traditional IRA scenario). You live another 30 years into your retirement, paying 12% on just the $30,000 of social security income, saving yourself a total of $292,000 in income taxes over the span of 30 years in your retirement compared to the Traditional IRA scenario. Instead, that extra $292,000 is actually allowed to continue to stay in your Roth IRA account and grow even further!
Why not both?
It’s important to point out that there are ways to take advantage of both the Traditional IRA and the Roth IRA. That isn’t the purpose of this post, but I will touch on that in a future post because it’s really cool information to have. As always, please speak with your tax consultant and pick the options that are best for you.
Caveats
So, two things that I also need to come back to. You can’t contribute more than you have earned in a tax year for both a Roth and a Traditional IRA. So if your earned income is $2,000, you can only contribute $2,000.
The second thing is that if you’re married and your spouse doesn’t work, as long as your earned income is greater than $12,000, you can contribute $6,000 into each of your IRAs.
But that is not all, we still have three more types of IRAs to discuss!
Rollover IRA
Another type of individual IRA is called the Rollover IRA. A rollover IRA is an IRA that originated from a retirement plan such as a 401k. When you leave an old employer, you can ‘roll over’ your qualified plan into an individual account known as a Rollover IRA.
When you leave a job, you typically have four options of what to do with your 401k at that employer.
- Leave the assets where they are (keep the 401k where it is)
- Transfer the assets from your old 401k to your new/current one if you have 401k options with your new employer
- You can take the cash out (if you are under the age of 59 1/2, there will be a penalty to do this)
- You can roll the assets over into an individual IRA with a Broker-Dealer of your choice
Now, I have never understood the thought of leaving the funds in an old 401k with a company you no longer work at. If one of you can give me a great reason, I’d love to know. I don’t like allowing people to have control of my assets. The old employer is no longer contributing to that 401k, and you don’t have the relationship with the HR department at the old company to ask questions and get help managing that 401k.
I have always liked the idea of moving the assets over to a 401k with your existing company if you may need to access it. This is especially helpful if you’ve built up a sizable 401k balance and may need to take a loan against it in the near future.
Keeping the assets in the 401k also makes sense if you’re in a business where you need the assets protected from lawsuits. (Some of this depends on what state you’re in).
Please don’t take a cash payout. This is one of the worst things to do. I understand if you’re in a crunch and times are tough, but this is meant to build and grow over time. You are heavily penalized for taking the money out early.
The last option is putting it in an individual account. This is my favorite option because of the fact that many 401k’s have very limited investment options. Inside an individual IRA though, you can buy stocks, bonds, mutual funds, ETFs, and low-cost index funds.
Simplified Employee Pension Plan
So for my business owners, this next one is for you! If you’re a solopreneur or have minimal employees (less than 5), this may be the IRA that you want to have a look at.
Here are a couple of key facts:
- An SEP is a form of an Employee Retirement Plan
- You can make higher contributions versus a Traditional IRA or a Roth IRA
- Employers are the ones that make contributions to the account
- Employees manage their own investments just like with any other IRA
As a small business, it can be pretty expensive to open up an employer-sponsored retirement plan like a 401k. Some start-up costs are typically associated with them as well as maintenance fees.
With the Simplified Employee Pension Plan, it costs far less to establish. As a business owner, you can put away a substantial amount of assets each year. This amount is equal to 25% of your income, up to $58,000.
The ideal scenario for this type of IRA is really for the individual business owner. The biggest catch for this type of plan is that if you have any employees and you would like to make a contribution to your own account, you must add a payment to theirs as well. This can potentially get expensive.
So, who should look at this type of vehicle? This is perfect for Authors, Freelancers, Gig Chasers, one man eCommerce stores, or anyone who manages the business by themselves.
SIMPLE IRA
The last IRA we will talk about today is the Savings Incentive Match Plan for Employees. SIMPLE for short. That one is far from SIMPLE though, it was quite a mouthful, actually!
So, what is a SIMPLE IRA?
This is a type of employer-sponsored investment plan and is meant for businesses with up to 100 employees. Anything more than that, and you likely want to take a look at a 401k.
So, what are some of the benefits and drawbacks?
- It is pretty quick and easy to set up
- Employees are allowed to contribute to the plan as well
- Lower contribution compared to some other plans
- You’re going to have to put in contributions for employees
The caveat is that you will have the ability to either match contributions up to 3% for employees or make blanket contributions for employees of 2% of their annual income. There isn’t really a right or wrong way to manage the contributions here. It will depend on your business model, profitability, and how much you want to give back to your employees.
One thing that should stand out to you is that the maximum contribution limits are a little lower than most other plans. In 2021, the max contribution allowed by the employee into the SIMPLE IRA is only $13,500. On top of that, they can either get a match up to 3% from their employer or a blanket 2% deposit.
Where can I set up an IRA or any of these accounts?
It isn’t as difficult as you would think to set up an IRA account. Pretty much any brokerage firm, bank, financial consultant, or RIA could help you. I’m a big fan of low-cost index funds, so I typically look in the direction of Vanguard, Fidelity, and Charles Schwab.
I’ll talk about some of the advantages of each in a different post. Still, you really need to be looking at the internal fees associated with your investments. Those three companies have low-cost index funds that can invest in the market as a whole.
When you’re saving 1% or more in fees, it can have a considerable impact on your portfolio over a 30-year time horizon.
Getting Rich Off IRAs
Before we close down, the most important question has yet to be answered! How can all of these IRA’s make me rich? Well that is a great question!
With a Traditional IRA, you can deduct the amount from your taxable income, dollar for dollar. This is a nice benefit. With enough deductions, you can decrease your taxable income down to zero. That means you could potentially increase your net take home pay anywhere from 12% – 32% or more.
With a Roth IRA, your assets grow tax deferred and are withdrawn tax free. That means if you let the account balance grow to $1,000,000, you have access to the full amount and Uncle Sam doesn’t get to dig his fingers into your assets.
In reality, to get rich on either of these involves a lot of discipline and consistency. Just like in the old folk tale of the turtle and the hare – slow and steady wins the race. In leveraging the investment power of IRAs you can make a significant financial impact to your overall wealth for retirement. Just make sure you are consistently adding more assets to your portfolio and maxing out your benefits each year. Over a 20, 30 or 40 year time horizon, you can see your retirement assets swell on even modest returns.
Final Thoughts
So we went over what IRA’s are and the various types. We walked through their uses with both benefits and drawbacks, and lastly, we discussed where you can go and open up an account to take advantage of these types of accounts.
That is a lot of information to digest, and I am super excited for you to tackle this article. I know that this is pretty surface-level stuff. I want you to get a solid foundation so that when you do start investing, you are doing it the right way.
Taxing advantage of the right accounts can help you start smart. Over time, by growing assets, you will be able to retire when you want and how you want. That is how you finish happy, and that is what I wish for you.
If you’re not yet ready to start investing because you feel that you have too much debt or too many expenses, take a look at the Debt Freedom Plan post and see if we can help you there.
If you’re looking to see how this can help you retire, look at the post about Compounding Interest here and how these types of accounts can catapult you to early retirement.
Disclaimer: JustMyLittleMess does not provide tax, investment, or financial services and advice. The information is presented without considering the investment objectives, risk tolerance, or financial circumstances of any specific investor. It might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.