An Individual Retirement Account (IRA) is a special type of account designed to help you save for retirement. It can provide many advantages over other types of investment accounts, including up-front tax deductions, tax-deferred growth, and more. But there are trade-offs as well, and an IRA is not right for every situation. So, before you go out and open an IRA account, let me walk you through the basic pros and cons.
But before we dive in, why am I writing a post on IRAs? Aren’t there already hundreds, if not thousands, of resources online on this topic?
Yes, but many if not most of them are technical and filled with financial jargon, and some of the rest are just plain full of misinformation. So, I thought it might be helpful to have a “plain English” walk-through of one of the basic financial tools for building long-term wealth.
An IRA is An Account
First of all, let’s start with the basics. For all the different types of IRAs out there, and all the different terms you may hear thrown around by the financial industry and the media, at its core an IRA just an account that has been specifically identified as an IRA according to the tax code. Whether it is a traditional IRA, rollover IRA, regular IRA, self-directed IRA, IRA certificate of deposit, deductible IRA, or nondeductible IRA, these are all essentially the same thing. The only reason they have different names is to emphasize that certain features are applicable to that particular IRA account, but all IRAs have the same set of features.
But, wait a minute. What is confusing is that not every account that has “IRA” in the name is exactly the same as those types listed above. For example, Roth IRAs, SIMPLE IRAs, and SEP IRAs are similar in many respects to an IRA, but they do have some important differences. SIMPLE and SEP IRAs are small business retirement plans, and Roth IRAs are much like an IRA turned inside out. You can read more about Roth IRAs here.
It’s Not an Investment
It’s also important to realize that an IRA is not an investment in and of itself. Rather, it is an account in which you put an investment. That may seem simple, but many people confuse those two things. I often get questions such as, “should I invest in mutual funds or an IRA?” That question betrays confusion on this point, so it’s important to realize that an IRA is just an account, and you can put all kinds of investments inside of it.
What kinds of investments can go in an IRA? The answer is just about any investment that you can buy outside of an IRA, you can also buy inside of one. From stocks, bonds, and cash to mutual funds, annuities, and even real estate, almost any investment can be held inside an IRA. Of course, the financial institutional holding and facilitating your IRA may limit your investment choices, but that is based on the choices available at that particular institution. (And of course there are some more “exotic” investments that by definition can’t be held inside an IRA, but that’s beyond the scope of this article.)
Roth IRAs Aren’t the Only Good Retirement Account Option
You read a lot about Roth IRAs, and how they are the ultimate in retirement savings vehicles. And while yes, there are a lot of great things about a Roth, you shouldn’t overlook the regular IRA completely. Here’s why: the main difference between a Roth IRA and a regular IRA is the tax-deduction. IRAs get an up-front tax deduction in the year you contribute, and the money can grow tax free for many years until you finally take the money out.
In addition, the law prohibits the same person from funding both a regular IRA and a Roth IRA to the maximum amount in any given year. So that means you have to choose between the two, should I save money into a Roth IRA or a regular IRA?
Since the main difference between them is the up-front tax deduction, the decision boils down to a question of tax brackets. An IRA is best for someone in a high tax bracket now, and who will be in a lower tax bracket in “retirement.”
A Roth IRA is the opposite from a regular IRA, you get no tax deduction up front, but you do get a tax break on the money you withdraw later on in retirement. So, it’s best for people in a lower tax bracket now, and who will be in a higher bracket when they start living off their nest egg.
But Here Comes The Gotcha
Now, the bad news is that while IRAs work best for those in a high tax bracket today, if you are employed in a job with a workplace retirement plan, such as a 401k, 403b, or pension, you may be limited in how much of a tax deduction you can get with an IRA contribution. For 2016, if you are single and make more than $61,000, your deduction is limited. If you’re married filing jointly, and make more than $98,000 as a household, you’re limited as well. So in this situation, it may be better to rely on the company retirement plan for tax-deduction opportunities, and if you still want to make additional retirement contributions above the company plan maximums, consider a Roth IRA, because the income limitations for Roths are higher than for IRAs.
You Can Rollover Your 401k Accounts into An IRA
Most people will own and use at least one IRA account over the course of their lives, either because they funded one directly or they transferred funds from a 401k. When you leave a job, hopefully there is a balance in your 401k account that you can transfer into an IRA. This transaction is called a tax-free rollover. You have to follow certain IRS-prescribed procedures (which are quite easy, any qualified financial advisor can help you), but if done correctly, the money is transferred tax-free and you can “take it with you” in your IRA account. That way, you are no longer limited by the company retirement plan’s investment choices, or subject to the 401k plan’s administrative fees (which are often higher than an IRA).