Some of the most frequent questions our clients ask are related to IRAs. What is the purpose and benefit of an IRA? What is the difference between a Traditional IRA and a Roth IRA? The purpose of this article is to help clear up some of the confusion.
First, what exactly is an IRA?
IRA stands for Individual Retirement Account. The key word here is account. An IRA is like a bucket to hold investments, so it is not considered an investment on its own.
In other words, if you are looking to invest in a particular mutual fund you can do this inside of an IRA account set up by a bank or brokerage firm. IRAs are simply the container in which individuals can invest on a tax-preferred basis.
How does an IRA differ from a regular investment account?
The biggest difference between an IRA and a regular investment account is in the tax advantages. IRAs were designed to help individuals build their retirement nest egg. Social security is often not enough to fund a desired retirement lifestyle, and IRAs are a great way to supplement retirement income.
A Traditional IRA is made up of pre-tax dollars. In other words, each time you contribute to a Traditional IRA, it reduces your taxable income in that tax year.
If you have a 401(k) plan through your employer, you can later roll that money from the 401(k) plan into your Traditional IRA account if you happen to leave your job.
Once money is in your Traditional IRA account, you can choose how it should be invested. Maybe you want to invest in individual stocks, an exchange traded fund, or mutual funds. You have control over that.
While IRAs do offer flexibility for withdrawals, you should never take the money out before you are ready to retire. If you withdraw funds from a Traditional IRA prior to age 59½ you will have to pay normal income tax in addition to a 10% early withdrawal penalty. This ends up being a hefty price to pay to access the funds. Even in high-need situations, it just isn’t worth it.
When you reach retirement age and are ready to withdraw from your Traditional IRA, know that every time you withdraw or take a distribution the money will be taxed at regular income tax rates. So let’s say over the years you’ve contributed $100,000 and, because your investments did well, it has grown to $300,000. When you withdraw this money, all of it will be taxed as income during the year it is withdrawn.
Contrary to a Traditional IRA, a Roth IRA is made up of after-tax dollars. In other words, contributions to a Roth IRA do not reduce your taxable income.
At first glance, it may seem like a bad deal. However, the real benefit of a Roth IRA comes when you go to withdraw the funds. Withdrawals from a Roth IRA are made tax-free, including all the investment growth. This can be a huge tax benefit.
Because of the big tax advantages offered by IRAs, the government limits the amount investors are able to contribute annually. This prevents people from taking advantage of the tax code. Both Traditional and Roth IRAs have 2017 contribution limits of $5,500 annually if you are under the age of 50, and $6,500 if over 50. Uncle Sam wants you to have access to tax advantaged accounts, but he doesn’t want you to get carried away.
The chart in this article goes over some of the key differences between Traditional and Roth IRAs. When thinking about whether you want to start a Roth or Traditional IRA, start by asking yourself, would you rather pay the taxes now or later?
There are many other nuances with IRAs that are important to keep in mind, but these are the basics. If you are curious about what type of IRA is best in your unique situation, give us a call. We’d be happy to answer any questions you have.