What is an IRA, anway?
As I talk with some of my friends, I discover more and more of them don’t have any idea what kind of retirement accounts are out there, or what kind of benefits these retirement accounts give. Some have heard of IRAs, some have heard of 401(k)’s and still more have decided to utilize their sock drawer as means of storing their wealth.
Basically for most people retirement accounts are broken up into three categories: Roth IRAs, Traditional IRAs, and 401(k)s. All have their advantages and disadvantages.
IRA’s in General: Tax Deferral!
One of the greatest things about IRA’s is that they are tax deferred! This means that if you have stock in a company which pays out a huge dividend you are not taxed on that dividend in the year you receive it! This is a huge benefit because it allows your money to compound at their highest potential, as opposed to take a 15%~45% tax hit every time you make a cent!
Roth IRAs: The “Tax Free Earnings” solution!
According to the IRS’s web site, Roth IRAs are:
“an individual retirement plan that, except as explained in this chapter, is subject to the rules that apply to a traditional IRA (defined below). It can be either an account or an annuity. Individual retirement accounts and annuities are described in chapter 1 under How Can a Traditional IRA Be Set Up…
…Unlike a traditional IRA, you cannot deduct contributions to a Roth IRA. But, if you satisfy the requirements, qualified distributions (discussed later) are tax free. Contributions can be made to your Roth IRA after you reach age 70½ and you can leave amounts in your Roth IRA as long as you live.”
In actual human speak, this means a few things.
1) Roth IRAs contributions are NOT tax deductible! This means you *will* have to pay taxes on the income that you deposit into the IRA account.
2) Only qualified withdrawals are tax free. “Qualified” basically means that you’ve had the account for at least 5 years, and that you have reached the age of 59 and 1/2.
3) Roth IRAs can exist forever. This means you do not have to withdraw constantly until the IRA reaches 0 by a certain age.
Those are some nice benefits. The main disadvantage is that you are going to be heavily taxed if you withdraw from a Roth IRA before you reach the age of 59 and a half. For those fo you planning to retire before the age of 60, this may not be your best choice. For those of you planning to retire later in life then this is a great option, because it means that the taxes you would pay on your earnings are non existent!
Traditional IRAs: The “Tax Deductible Contributions!” Solution!
Traditional IRAs are significantly different that Roth IRAs. According to the IRS website, Traditional IRAs are, and I quote:
“A traditional IRA is any IRA that is not a Roth IRA or a SIMPLE IRA.”
It then proceeds to give us a good 50 page document. The main gist of the document when comparing to Roth IRA’s three main points are this:
1) Contributions can be tax deductible! There is a really complicated method of figuring this out, and I would suggest talking to someone who actually knows taxes intimately to see how much of a deduction you would qualify for.
2) Withdrawals from a traditional IRA are taxed. There are some exceptions, but in general your withdrawals will be taxed as income in the year you make the withdrawal.
3) Tradition IRA’s must start having withdrawals by the age of 70 and a half. Basically if you don’t start withdrawing, you can get taxed heavily. Up to 50%!
In conclusion, Traditional IRA’s have some weird rules about them. They can get confusing, but if you intend to retire early they can be beneficial because you don’t get a penalty slapped on you if you decide you don’t want to work till your 60 before you start using your IRA. Roth IRA’s are also nice, because they allow you to have all of your dividends, interest, and assorted income completely tax free! However the restriction of waiting till your 59 and a half before you even get that advantage is sort of irritating.
I personally have a Roth IRA account, but am considering switching to a traditional due to the tax deductible nature of its contributions. I also plan to retire before I’m 59 and a half, so I want to avoid having to pay the penalty if I do withdraw before then… Yarr. Decisions!
—Zach
