I still find people who tend to pooh-pooh being told to use an IRA to save for retirement. They assume that they’re saving enough through their workplace plan, or that they are going to hit the jackpot just in time with their company equity, or that Social Security will take care of them. Ok, not really a plan, but nice to dream about. You may be saving the maximum through your employer plan, but do you really want all of your money for retirement to be in that one account? And who doesn’t want more money in the future? There are many reasons to save additional in an IRA and it can make a big difference. Let’s take a look at some basics, and some projections.
So, what is an IRA? IRA stands for Individual Retirement Account. There are several types of IRAs, but this blog post will focus on the two most common: the traditional IRA and the Roth IRA. The IRA itself is not an investment, it’s an account type and you make investments within the account. At their most basic, both IRAs share some common features; individuals can set aside personal savings from earned income ($6,500 per year as of 2023, over age 50 you are allowed an additional $1,000 catch-up contribution), both provide tax advantages in their own way, both allow for spousal IRAs for non-working spouses, and both may be protected from creditors in bankruptcy proceedings. But as with all things investing and governed by federal law and the US tax code, things aren’t always that simple.
With a traditional IRA, you make contributions which may be tax-deductible. I say ‘may’ because you might be in a situation where contributions to your traditional IRA are not tax deductible depending on your income, employer plan coverage, or your spouse’s coverage. Your contributions grow tax-deferred until you make a withdrawal – a distribution. Your distribution is taxed at ordinary income tax rates provided you are age 59 1/2 or older. If you are under age 59 1/2, your distribution may be subject to a 10% penalty in addition to ordinary income tax. This penalty can be avoided if the distribution is for qualified education expenses, first-time home purchase (up to $10,000), or unreimbursed medical expenses in excess of 10% of your AGI if you are under age 65 (7.5% if over age 65).
With a Roth IRA, you make post-tax contributions (i.e., no current tax deduction available). There is no RMD requirement with Roth IRAs. Three are, however, income limits on who can contribute but these can be less of an issue if you are able to do a backdoor Roth IRA contribution. Please note, if you already have an existing traditional IRA, you may be subject to the pro-rata rules and your contribution may be taxable. Your Roth IRA contributions grow tax free and if your distribution is a qualified distribution, it is tax free! If you happen to take a distribution prior to age 59 1/2 and have owned your Roth IRA less than five years you’ll owe taxes and a 10% penalty on your earnings portion of the distribution. Like the traditional IRA, this penalty can be avoided if the distribution is for qualified education expenses, first-time home purchase (up to $10,000), or unreimbursed medical expenses in excess of 10% of your AGI if you are under age 65 (7.5% if over age 65). There are a few other exceptions as well so be sure to check with your tax preparer. The five-year rule is also complicated by how old you are, and how long you have owned the account. On the bright side, with a Roth IRA you can always withdraw your personal contributions if needed without incurring tax.
Those points are just some of the IRA basics. Of course, given the tax code you may be in a unique situation so consider talking to your financial planner prior to making any distribution.
With the rules around IRAs, you may be asking why bother with having one? Well, because they are still a valuable component of your retirement planning. Even if you are fully funding your workplace plan, an IRA can really boost your wealth. Let’s take a look.
For parameters, we are going to make some basic assumptions. First, that you are single, starting at age 30 and contributing the fully allowed annual amount (plus age 50 catch up), you earn $80,000 per year, and are stopping contributions at age 60. Congrats! Early retirement. We are also going to use the AARP IRA Calculator because it is able to include the age 50 catch up adjustment for us and show us the after-tax value of a traditional IRA. The AARP Calculator does use the historic 7% return.
With those parameters in mind, just how much more retirement does your IRA buy you? The answer – A LOT! In our example you would have over your life personally contributed $205,000 and your traditional IRA balance before taxes would be approximately $671,758 ($615,513 after taxes if you are in the 12% bracket in retirement). At a recommended 4% per year drawdown, that adds an extra $26,870 per year (before tax) to your annual income to go along with any other income streams such as your workplace retirement plan, any pension, and Social Security. If it’s a Roth IRA, you should have the full $671,758 and the annual $26,870 available tax free!
What if you just can’t do the annual maximum of $6,500 (which does increase periodically due to inflation)? Let’s say, you are contributing at work and only have $100 per month left over to invest in your IRA. Same parameters, but a different amount. You still add about an extra $121,288 to your retirement savings. True, it’s not a lot in comparison, but it only cost you $36,000 over your 30-year investment period. In addition to any Social Security, pension, or workplace plan, it’s still a nice bonus to work with.
It should be noted that the Trump administration effectively killed the ability to pass down wealth to your children or other beneficiaries and stretch it over their lifetime with passage of the SECURE Act in December 2019. Now, if you passed that $671,758 to your child or other beneficiary, they generally only have 10 years to drawdown and empty the IRA. That’s right, evenly spread the recipient would be adding just over $67,000 in additional taxable income to their annual income! Surviving spouses, minor children, individuals not more than 10 years younger than the original owner, and certain chronically ill or disabled recipients are exempt from this 10-year rule nightmare. Roth IRAs are a bit more complex because the five-year rule comes into play.
Even with the inheritance scenario, saving in an IRA still makes sense. Selecting a traditional IRA or a Roth IRA depends on your personal situation and goals. Whether you can contribute the maximum, or make a $100 monthly contribution, it’s still a good idea to create that extra income for yourself. As an independent CERTIFIED FINANCIAL PLANNER™, I can help you select which IRA is right for you. Contact me and let’s get started on creating some extra money for your future. #talktometuesday #financialplan #letsmakeaplan #CFPPro #todolist #moneydolist #RothIRA #IRA #Roth #saving #investing #money