IRA stands for Individual Retirement Account. There are two primary types, Traditional IRA and Roth IRA. In this post I’m going to give you the basic information you need to help determine which type is best for you to contribute to annually.
Employee Retirement Income Security Act
In 1974 the Employee Retirement Income Security Act was signed into law and Traditional IRAs became available for the first time. These retirement accounts allow most taxpayers to make contributions to an account in their control and invested at their discretion. The money is contributed, in most cases, pre-tax, which allows a tax deduction to be taken on their tax return for that year. The money in the account then fluctuates based on the ebb and flow of the market and how it’s invested, with gains and losses occurring over time. These gains and losses are not realized on the tax return, but instead happen behind a tax-deferred barrier. This means the money can grow without being taxed right away.
The Taxpayer Relief Act of 1997:
The Taxpayer Relief Act of 1997 introduced a new type of IRA, the Roth IRA. These operate somewhat similarly to Traditional IRAs, but with different rules. Most importantly is that your contributions are made post-tax rather than pre-tax, which means you do not deduct your contributions to the account on your tax return. You get NO upfront benefit from making contributions to the Roth IRA. The real benefit comes from the back end, when the account has been open for at least five years and you’ve reached age 59 ½. Upon taking distributions from the account then, the distributions are tax free. This means if you put $5,000 into the Roth IRA at age 50 and never put another dime in, then 10 years later fully distribute the account which is valued at, say, $6,000, you wouldn’t recognize any of the gain as income and would receive the full distribution tax-free. Obviously as the numbers scale up Roth IRAs just look better and better.
Ultimately you must decide if you want up front tax savings or wait for your savings on the back end. The Roth IRA has the greatest potential for overall savings as your account has unlimited potential growth. This makes it the IRA of choice for many people. However, there are two additional points you should consider before closing the book on this, and those are the compounding nature of tax savings and the concept of “principal investing power”.
Money is a finite resource, you only have so much of it. In the scenario in which you’re considering contributing $2,000 to an IRA, but you don’t yet know which one you want to contribute to, you can actually afford to contribute more to the Traditional IRA. By contributing $2,000 to a Traditional IRA, in a 22% tax bracket, you save $440 in taxes. This means that you could contribute $2,500 to the Traditional IRA, which would save you $550 in taxes, and then put that $550 in your bank account and it’s as if you were only out $1,950. When you contribute $2,000 to a Roth IRA your bank account is just out the $2,000.
Now regarding “principal investing power” I’ll use an example. If you invest $100,000 and I invest $10,000 and we both get a 5% rate of return on our investments, who earns more? You do, of course. The more you invest the more you earn, compounded enough times this becomes hugely relevant. Now apply that to our previous learning about compounded tax savings. The Traditional IRA holder contributed $2,500 and only lost $1,950 from their bank account while the Roth IRA holder contributed $2,000 and lost that $2,000 from their bank account.
The point here is that the Roth IRA has some huge advantages, but the Traditional IRA isn’t something to be dismissed either. Generally speaking, the younger you are the more attractive Roth IRAs should be to you. I generally prefer Roth IRAs over Traditional IRAs, but both have their place in the financial world.
The final consideration is whether you’re eligible to contribute to the IRA of your choice. Roth IRAs have an income limit of about $120,000 or single filers, $189,000 if you’re married. If your income is above that threshold your contribution may be limited or prohibited entirely. For Traditional IRAs it depends whether you have an employer sponsored retirement plan or not. If you do not, there is no income limitation for Traditional IRA contributions. You should consult with your tax advisor before making any contributions to a retirement account.
If you don’t have a tax advisor you should contact us at Molen & Associates. These types of conversations will occur naturally when discussing your finances each year with your advisor. If you have any additionally questions regarding this or any other subject please let us know by calling us at (281) 440-6279 or by email to info@molentax.com. We’re happy to give you a free 15-minute consultation to help you get your taxes and finances back on track.
Keep an eye out for our upcoming “Backdoor Roth IRA Strategy” follow up post, which will give you more insight into how you can contribute to a Roth IRA even if you exceed the income limitations.
