A topic I often have to address is, 'What is an IRA?' It is a question I have to discuss with my customers, and some of my coworkers, about on a regular basis. Understanding what an IRA is, and how it will benefit you when it comes time to retire, are important to know when planning how much money will be available when you retire.
What is an IRA?
An IRA, or Individual Retirement Account (though, I see from the IRS that it is now referred to as 'Arrangements'), is an individual plan to set aside money for use when you reach a certain age (as of today, April 2014, that age is at least 59 1/2). The money is treated differently for tax purposes than a standard savings or investment account, but it comes with certain limitations and requirements. The complete scope of the IRA can be found on the IRS website. This article is not meant to be the definitive study of the IRA, but is meant to discuss highlights of the IRA so you can make a more educated decision about how an IRA will work in your retirement plan.
First, you must understand that there are actually two distinct IRA options available to you. The first, and more common IRA is referred to as a Traditional IRA. When IRAs were first created, this was the only option available to the public, and when most people think of IRAs, they are often thinking of the Traditional version. The second, more recent creation, is called the Roth IRA. Named after the former Senator from Delaware, William V Roth, Jr, the Roth IRA has only been in place since 1998.
Though they are both IRA accounts, they are treated differently under the tax laws. They each have their own tax advantages, but the differences can affect you both when you contribute as well as when you retire.
First, the Traditional IRA...
The Traditional IRA allows you to avoid paying taxes in the tax year you contribute money to your account(s). For every dollar you contribute, you get to subtract that money from your income for that tax year. This allows you to avoid paying taxes on the money in that year, thus lowering your tax bill.
As an example, if you contribute $5000 to your Traditional IRA, then you can subtract $5000 from your earned income for that tax year. If you pay a tax rate of 10% (this number is used for simplicity, as the actual tax percentage will vary significantly from individual to individual), then this will save you $500 off of your taxes for that year. This means that, to put $5000 into your account only truly cost you $4500 (as you get to keep $500 you would have otherwise paid in taxes).
That may sound great, until you reach retirement. At retirement, you have to pay taxes on the amount of money you take out of your IRA as if you earned that money that year. This would be on top of any other income you earned. So, looking at the numbers again, if you are still paying taxes at 10% and you withdraw your $5000 (in this assumption, we will assume you earned no money on your IRA), you would pay taxes on that $5000 income. At 10%, this means you pay $500 in taxes in the current year. So, you get to keep $4500. Doesn't sound tax advantaged at this point, but you didn't make any money on the investment. It also assumes you pay the same tax rate, when in reality you often pay a lower rate in retirement because you are not earning as much money in retirement as you did working up to retirement.
Whether you earn money on your investment, or you lose money on your investment, you will pay taxes on every dollar you remove. So, if you lose half of your money and withdraw $2500, you will pay taxes on the $2500 (at 10%, $250). However, if you double your money to $10000, you will pay taxes on the $10000 if you withdrew it all (at 10%, $1000). The key is, you are hoping your tax rate is higher when the money goes in than when the money comes out, as the tax savings will help with your return. We are only using the fixed 10% for simple numbers, but since the top tax rate as of April, 2014 is 39.6%, if your tax rate is lower in retirement it adds to your tax benefits.
Next, the Roth IRA...
If the biggest tax benefits of the Traditional IRA occur in the year you contribute, then the Roth IRA's biggest tax benefits occur then you withdraw the money. Any money you contribute to the Roth IRA is taxed like any other income you earn in that tax year. However, the biggest advantage available to the Roth IRA is the tax free earnings that occur.
So, again, we will take our theoretical $5000 contribution, but instead of a Traditional IRA, we will contribute it to a Roth IRA. If my tax rate is still 10%, I will pay taxes on that $5000 (just like I would if I didn't contribute anything to an IRA), for a total of $500 in taxes in that year. So, that $5000 contribution will cost me $5000 (I would have paid the taxes anyway, so the taxes I pay don't add to the cost).
Now, that doesn't sound like much of a deal, until you reach retirement. At retirement, you can withdraw any of the money tax free. You paid the taxes on the way in, you don't have to pay the taxes on the way out. So, if we look at these numbers again, if we are still paying 10% taxes, and you withdraw your $5000 from your Roth IRA (again, the assumption is your IRA earned you $0), you would not pay taxes on your $5000. This doesn't sound like any sort of deal at all, except you didn't earn any money on the investment in this example. The tax rate becomes irrelevant, as you paid taxes on your initial earnings but do not pay any taxes on your withdrawal.
The benefit comes in if you earn money on your investment. If you can double your $5000 to $10000, then you will pay $0 in taxes on the $10000. This is where the benefits really kick into gear. This only assumes you double your money. If you took your $5000 and invested it with Bill Gates to found Microsoft (he only paid $50,000 for DOS), then you would be worth 1/10th of Bill Gates' net worth, or roughly $7.7B as of 2014). You wouldn't pay a penny in taxes on those gains. Now, this is of course impossible, as the Roth IRA was founded in 1998 and Microsoft went public in 1986. However, the factors are intended as an extreme example of how the Roth IRA works.
The downside comes if you lose money in your Roth IRA. You don't get any of the 'tax benefits' of losing money (though they don't add insult to injury and charge you for taxes like the Traditional IRA). If your $5000 is only worth $2500 in retirement, when you withdraw the money you will pay no taxes, but have no upside, either.
Which IRA is right for me?
You want me to answer that, don't you? You want me to tell you the correct answer for you is ...
I can't do that, because every situation is different. I can only give some things to consider. The 'correct' answer is there is no 'correct' answer. Also, choosing an IRA path is not like deciding to circumnavigate the globe to the east or to the west. You can choose both. You can even choose both in the same tax year (though you are limited in how much you can contribute in total, as of 2014 this amount is $5500, or $6500 if you are over 50 years old).
If this year, you choose to invest $5500 in a Traditional IRA. Next year, you can contribute $2500 in a Traditional IRA and $3000 in a Roth IRA. The combinations are virtually limitless, up to that maximum contribution limit.
When is an IRA right for me?
This answer is easier. If you ever want to retire, the best time to start is yesterday. Since this is, of course, impossible, then today will have to do. Even if you only start small, you should start. Even if you don't reach the annual maximum, you should start. Even if you don't know what to put your money into, you should start.
Your bank will have basic products to assist you. A savings account is ideal, as it allows you to add money whenever you wish. A certificate of deposit (or CD) is a next best choice. The CD will often have a better return, but you have to wait for the CD to mature before you can add more money. Anything beyond that, if you don't have any experience your self, I would recommend getting assistance from a licensed advisor.
While I cannot give you the right answer for your situation, I can tell you that you don't need the right answer, simply a plan to move forward. Start small if you must, but start. Every dollar you invest today should be worth more in the future. At the very least, it will save you money on your taxes this year (in a Traditional IRA). Money you keep in your control will give you more options when you retire. The minute you hand over that money to someone else, through taxes or buying 'stuff', you take control away from yourself and put it in the hands of others. The IRA is an important part of planning for retirement. I recommend you start that plan today.