Explanation and Details
What are IRAs?
An individual retirement account (IRA) is a tax-advantaged investment account available to individual investors. Many individual investors use IRAs for a variety of reasons ranging from allowing greater investment growth to reducing their current taxable income to passing tax-advantaged accounts to their heirs.
IRAs are a government-created tax sheltering vehicle available to most individuals. The objective in offering this tax-advantaged program is to encourage greater financial independence and stability among American retirees, i.e. not to rely solely on a company pension, 401k, or social security.
Typically, individual investors using an IRA will need to choose between a Traditional IRA or a Roth IRA.
How IRAs Work
The basic concept of IRAs is to allow individual investors to either not pay income taxes on investment money upfront or pay taxes upfront now and not in the future. In both cases, individual investors will benefit from not having to pay capital gains taxes on their investment’s growth in an IRA account.
If an eligible investor chooses not to use an IRA, they will not only have to pay income tax on the money they are investing for the future but in the future when they sell their investment, they will need to pay an additional tax called capital gains tax. By using an IRA, an eligible investor can “shelter” their investment from future capital gains taxes and still retain control over their investing decisions.
In addition to the tax benefits IRAs offer, the control over investment decisions mentioned above increases IRA’s popularity as either a main or supplementary retirement vehicle. This feature of IRAs contrasts many employer-sponsored retirement plans, such as 401Ks, since often the employee has a limited selection of investments available to them. Often these investment options are limited to a predetermined selection of mutual funds or ETFs.
With IRAs, investors can hold a range of financial products including stocks, bonds, mutual funds, ETFs, commodity funds, and in some cases tangible real estate. This means an investor using an IRA account could employ pretty much any investing strategy they choose, from holding only a few stocks (undiversified and risky) to owning several stocks, a few mutual funds, and maybe a bond or two (diversified and less risky). In this sense, IRAs would be comparable to simply opening an online brokerage account and buying whatever.
Where IRAs differ, in addition to tax sheltering, from just opening a brokerage account and buying a selection of stocks is that the amount deposited into an IRA account is “stuck” in the IRA until the age 59½. So, where in just opening a normal brokerage account an investor could withdraw money from the account to buy a car or pay a bill, in an IRA account, the investor cannot withdraw their investment without a significant cash penalty.
Key Points
- Individual Retirement Accounts (IRAs) are a taxed advantage investing account – shelter income
- IRAs are owned by an individual and not sponsored by a company
- IRAs offer the investor a wider option of investments to purchase than 401Ks
- IRAs lock up the investments made into them
Types of IRAs
For individual taxpayers, there are two types of IRAs available to use, traditional and Roth. Which one is better to use will depend on the investor’s goals, age, and current income level.
Traditional IRA
With a traditional IRA, the amount an investor adds “contributes” to their IRA account is tax-deductible. This means, the amount an investor adds to this account is not taxed and makes their income look lower than it is -possibly lowering their income tax bracket.
For example, if an investor contributes $6,000 to a traditional IRA and is in the 24% income tax bracket, the $6,000 contribution could reduce their tax bill by $1,440. The reason for this is that with a traditional IRA the investor will pay income tax in the future when they withdraw from their account.
Since investors differ income taxes on the money they invest into a traditional IRA, the government ends up wanting their tax money and mandates withdrawals from traditional IRAs so they can tax them. This means at age 72 the investor must begin taking what is called a required minimum distribution (RMD) or potentially be subject to a tax penalty of 50% of the RMD value.
The RMD will be different for each traditional IRA as the calculation for RMD is dependent on the size of the IRA and life expectancy. Generally, having a required minimum distribution makes it harder for an investor holding a traditional IRA to pass on their IRA investment to their heirs as the government is essentially clawing back its delayed taxes before the investor’s death.
Things to consider with a Traditional IRA
The main thing to consider with a traditional IRA is the tax bracket you are currently in vs the tax bracket you will be in the future. If you’re paying a high tax rate now but expect to pay a lower tax rate later on then a traditional IRA may help reduce your tax bill over time.
Do you want to be forced to withdraw?
An additional consideration with traditional IRAs is do you want the money to be locked up? That is, you will not have access to these funds until retirement without incurring a seriously large penalty.
Roth IRA
With a Roth IRA investors pay regular income tax upfront on the amount they add “contribute” to their IRA account, however, when they eventually withdraw money from this account it is not subject to tax, income, or capital gains.
For example, say an investor wants to put $6,000 of their income to their Roth IRA and is in the 22% tax bracket. This investor will pay $1,320 in tax on that $6,000 upfront meaning their effective contribution would be $4,680. When they withdraw, however, they will not be subject to income tax on that withdrawal-like in a traditional IRA nor capital gains tax.
Since the investor has already paid taxes on what they’ve invested the government doesn’t mandate a required minimum withdrawal (RMD) from Roth IRAs. Meaning an investor who doesn’t need to withdrawal from their retirement account during retirement can allow their investments to continue to grow uninfringed and not subject to any taxes.
Often, the ability to not take RMD and allow investments to grow becomes very appealing to individuals who will be well off through retirement. This allows them greater control over their ability to pass investments on with additional tax benefits. Additionally, having already paid taxes on these investments means if the investor is in a higher income tax bracket than when they initially invested end up with tax savings.
Things to consider with a Roth IRA
The main thing to consider with a Roth IRA is the tax bracket you are currently in vs the tax bracket you will be in the future. Typically, the Roth IRA is appealing to young individuals since they likely are in a lower tax bracket than they will be in 10 to 15 years in addition to no mandated withdrawals.
An equally important consideration is if you will need the money in the future. This could be for a house down payment, buying a car, or paying bills. When money is deposited into a Roth IRA account it becomes very difficult and expensive to withdraw.
Of the two IRAs available to individual taxpayers, Roth IRAs are much easier to pass to heirs without needing to make adjustments. If you have no need for the money and want to leave heirs money, a Roth IRA may be easier.
Math Behind an IRA
So how does the math work out between the two IRA options? Which IRA option gives you more money at the end? The short answer is, they’re the same. To make this point we can look at an example comparison between a Roth and Traditional IRA.
Traditional IRA
Let’s say we’re in the 24% tax bracket and want to open a traditional IRA, in addition to this we will contribute the current maximum of $6,000 to our new account.
To keep things simple, let’s say that after we contribute this $6,000 we don’t put any more money into our traditional IRA account. If we’re in our mid-20s or early 30s and let our $6,000 investment grow for the next 40 years (it’s locked-up so we don’t really have a choice) at just a realistic 10% our IRA will be $271,555.
Continuing to keep things simple, at this point we’re assuming we’re still in the 24% tax bracket and ready to retire. If we were to take all the money out at this point our ending after-tax amount would be $206,382.
Not too bad but how does this compare to the Roth IRA?
Roth IRA
Let’s take the scenario we used above and only change the IRA that we are using. We are still in the 24% tax bracket, still putting $6,000 of our income into the IRA, we’re still in our mid-20s or early 30s meaning this money is “locked-up” for around 40ish years, and we are still earning a respectable 10% annual return.
With our adjustments to the scenario we end up putting $4,560 into our Roth IRA after taxes and our investment grows to $206,382 if we were to take all the money at this point.
Conclusion
Both the Traditional IRA yield a net of $206,382 and the Roth IRA yield a net of $206,382 When everything is equal.
So, here’s the point, what really decides which IRA is “better” is not the effect paying taxes now or later has on your investment. It’s the percentage of taxes you pay and the length of time you are allowed to compound your investment.
Income Limits, Contribution Limits, and Withdrawal
Similar to all good things, there are limits to how much an investor can contribute to an IRA. Currently, individual taxpayers cannot exceed a $6,000 annual contribution to either a Traditional or Roth IRA unless they are over 50 in which case they can contribute $7,000 with catch-up contributions.
In addition to contribution limits, for traditional IRAs, there are tax deduction limits based on income. Similarly, Roth IRAs have income limits as well where they are no longer available to individual taxpayers. Since these Income limits change fairly regularly, we have included them in the table below.
Details Table
We have included a detailed table of the contribution and deduction limits for Traditional and Roth IRAs below:
Traditional IRA Deduction Limits 2021
| Filing Status | 2021 Income (MAGI) | Deduction |
|---|---|---|
| Single/Head of Household | $66,000 or less | 100% Deduction of Contribution |
| Single/Head of Household | $66,000 to $76,000 | Deduction Phaseout / Partial |
| Single/Head of Household | Above $76,000 | No Deduction |
| Married Filing Jointly | $104,000 or less | 100% Deduction of Contribution |
| Married Filing Jointly | $104,000 to $125,000 | Deduction Phaseout / Partial |
| Married Filing Jointly | Above $125,000 | No Deduction |
Roth IRA Contribution Limits 2021
| Filing Status | 2021 Income (MAGI) | Contribution |
|---|---|---|
| Single/Head of Household | $125,000 or less | 100% to Limit |
| Single/Head of Household | $125,000 to $140,000 | Partial Contribution |
| Single/Head of Household | Above $140,000 | Direct Contribution not Allowed |
| Married Filing Jointly | $198,000 or less | 100% to Limit |
| Married Filing Jointly | $198,000 to $208,000 | Partial Contribution |
| Married Filing Jointly | Above $208,000 | Direct Contribution not Allowed |
Benefits & Drawbacks
Roth IRA Benefits
- No required minimum distributions
- Shelter from capital gains tax
- Investment account is open to almost any investment
- Gains on invested money is not easily withdrawn
Traditional IRA Benefits
- Taxes are differed to the future
- No income limits to contribute to a traditional IRA
- May reduce tax bill and tax bracket
- Future gains are not subject to capital gains tax
- Investment account is open to almost any investment
- Money is not easily withdrawn
Roth IRA Drawbacks
- Taxes must be paid upfront
- Gains on invested money is not easily withdrawn
- Limited contribution amount and limited based on your income level
- Some investments cannot be used within IRA
Traditional IRA Drawbacks
- Taxes must be paid later leaving the investor open to income tax increase risk
- Comes with required minimum distribution meaning these funds typically cannot be held late into life.
- Money is not easily withdrawn
- Limited contribution amount
- Some investments cannot be used within IRA
Helpful Links
Calculate Required Minimum Distribution
Current Deduction and Contribution Limits
Frequently Asked Questions
IRAs are individual retirement accounts funded completely by an individual taxpayer, whereas 401Ks are employer-sponsored retirement plans. With 401Ks some of the money in a 401K plan is deposited by the employer on behalf of the employee in addition to what the employee contributes.
An individual retirement account (IRA) is a tax-advantaged investment account available to individual investors. This type of account allows investors to choose when they pay income tax on the money they contribute to the account in addition to being exempt from future capital gains tax.
Typically, 401Ks are cheaper for individuals to participate in than an IRA. In the case of an investor who’s extremely passive in their investing strategy, a 401K may be better. However, IRAs give investors an incredibly larger number of investment options. So, in the case of an engaged investor, an IRA will likely be a better choice.
*Lottie animation is from lottiefiles.com and was created by KC Woon
