In our last article, Uncle Sam’s Cut, we learned how the government wants to take a bite out of all the profits you make. For some individuals this could be as much as 30-40%! If we want to fully utilize the power of compounding in our account, we will want to save as much of our profits as we can. Luckily, there are a few investment vehicles at your disposal to do just that. The ones I’m going to be discussing today are Individual Retirement Accounts, or IRAs. You might have heard of them before. They are often talked about in commercials you see on television.
When you open a brokerage account it’s going to be classified as a fully taxable account. Buys and sells you make will be subject to capital gains tax and dividends you receive will also be taxed as well. A retirement account is what’s known as a tax-sheltered account. If you are already working a full time job you very well could have a tax-sheltered investment vehicle known as a 401k or 403b.
These plans are great because you decide what percentage of your paycheck you would like to go into the plan and your employer will often match that contribution up to a certain percentage. That’s free money you are getting and it is helping you save! The money that is put into these plans is invested in a vary of mutual funds or stocks depending on the companies plan and they grow tax-deferred in the account. What this means is that if securities (stocks/mutual funds) are bought and sold within the account you do not have to pay taxes on that money. The catch is that you have to pay taxes on the money when you pull funds out of the account at a later time, usually retirement. The key is that by not paying taxes during the life of the plan, the account can grow at a much faster pace.
IRA accounts are something separate that you can set up but have the same tax sheltered properties. There are two main IRAs that you can set up and invest in. One is called a Traditional IRA and the other is a Roth IRA. Let’s start with the table below to see the differences between the two.
|Traditional IRA||Roth IRA|
|Contributions||Pre-tax dollars (Pay taxes later)||After-tax dollars (Pay taxes now)|
|Contribution Limits||For tax years 2015 and 2016: up to $5,500; $6,500 for those age 50 and over||For tax years 2015 and 2016: up to $5,500; $6,500 for those age 50 and over|
Let’s dissect the chart so we get a better understanding of everything.
Pre-Tax vs. After Tax Dollars
The main difference between the two is that the traditional IRA is made with pre-tax dollars while the Roth is made with after-tax dollars. What this means is that the funds going into the traditional IRA will be taxed when they come out later and the funds that are going into the Roth will be taxed now. Why does this matter? Why make the difference between the two? One reason is that many people anticipate that they will be in a higher or lower tax bracket years down the line. Let’s say I earn about 70k each year now and I plan on retiring around 60 years old. Since I plan on being in a much lower tax bracket then it would be advantageous to open the traditional IRA. When I retire I would have to pay less in taxes on the money I pull out. The opposite would be true with a Roth. I pay taxes on the money I put into the account now, but later I can pull out funds completely tax free.
While you can contribute an unlimited amount to a brokerage account, IRAs have contribution limits. You can contribute a maximum of $5500 per year of EARNED INCOME to these accounts and $6500 a year when you turn 50. I emphasize earned income because it cannot be from income you receive from investments. Let’s say you own shares of IBM and you receive $200 dollars in dividend income from them every quarter. You cannot put this money into a retirement account because it is not earned income.
Both of these account require you to have earned income to contribute. Eligibly comes into pay when you make too much earned income. You may not be eligible to contribute to a Roth IRA if your income is $132k or more in tax year 2016 for single filers or $194k or more in tax year 2016 for joint filers. This is dollar figure is subject to change every year.
Even though the government allows you to invest in these tax-sheltered vehicles you have to know that there will still be a catch. The funds within the account can grow tax free as long as you do not pull out funds before you are 59 and ½. If you do pull out funds before that time you will receive a premature penalty which is often 10% in addition to being taxed on the funds themselves. In a Roth IRA you can pull out your contributions penalty free but not earnings. For example, let’s say you put 5k into the Roth and invest it in a few stocks. After a couple of years, the value in the Roth has grown to 7k. You can pull out 5k that you contributed but anything more than that would be earnings. If you were to pull out the full 7k then you would be subject to penalty on that 2k difference. There are qualified withdrawals that are penalty free like the table says but it’s always best to consult with a tax advisor to make sure. Ideally, you want to let this money sit and grow until you can pull it out of the account penalty free for retirement.
I highly encourage you to explore these vehicles as they provide you with a great way to build money tax free over many years. I’ve said it before but we want to maximize the power of compounding. Even if you have a 401k or 403b, I believe you should contribute to an IRA as well. Even if you can only contribute a small amount each year to these types of accounts, you will be thanking yourself at retirement.
Personally I believe that the Roth IRA is the better pick if you are eligible. You may think that you will be in a lower tax bracket later in life but you never know! How can we possibly predict what our life will be like 20, 30, 40, 50 years down the line?? Additionally, think about the whole goal of opening a retirement account in the first place. We want to slowly put small amounts of money into it so it can grow and compound into a LARGE sum of money. Would you rather pay taxes on smalls sums of money now or LARGE sums of money when you start to take withdrawals? I personally think you will pay less in taxes in the long run if you invest in a Roth account. Plus, you don’t have to worry about it later in life!
Homework: If you already contribute to a 401k or 403b, find out how much you contribute each year if you don’t already know. Make a plan to start contributing to an IRA account. If you can’t afford to invest the full 5,500 that ok! Small contributions to these accounts over time will really make a huge difference. Even if it’s just $50 dollars a month!