So you’ve decided to save for your future and open up an IRA, great job. This is a powerful first step in assuring your Golden Years are just that. An IRA is an individual retirement account, where participants make contributions (buy investments)-with the end goal of having a large enough balance to enjoy a stable retirement. As an incentive to utilize these investment vehicles, the government allows some tax benefits, either tax-deferred or tax-free growth.
There are a many types of IRAs available, simple IRAs, myRAs, SEP IRAs, education IRAs, self-directed IRAs, traditional IRAs and Roth IRAs but the most common are traditional and Roth IRAs. The problem is deciding which one is better for your situation.
What’s the Difference Between Roth IRAs and Traditional IRAs?
The IRS will receive its taxes, one way or another. What that means with regards to an IRA is participants either pay the income taxes up front or later on. For a Roth IRA, you make after-tax contributions on your income (you pay the taxes up front) then make the contribution with those funds into the account. Since you’ve already paid taxes, the earnings and gains in the IRA grow completely tax-free. But since you receive the money tax-free when you retire, your initial contributions are NOT tax-deductible.1
The Roth is a great deal but there are income limits to qualify for participation. According to the IRS, if you are single, the head of a household or married but filing separately AND earn less than $117,000 (as measured by modified adjusted gross income) you can contribute up to the full limit, which is $5,500 for 2016.2 If you make between $117,000 and $132,000 you can contribute a partial amount but if you earn $132,000 or above you are not allowed to contribute.3
For traditional IRAs, you don’t pay the taxes up front out of your income, you defer paying them until you withdraw the money from your IRA account. When you withdraw the money you will have to pay taxes on the earnings and gains in the account, not the contributions. But if you withdraw the money early (before age 59 ½), you’ll incur a 10% penalty, plus owe the income taxes that you were required to pay anyway.4 For a traditional IRA, you can contribute up to the limit, $5,500, regardless of income.
Unlike the Roth, U.S. tax code allows traditional IRA participants to deduct the contribution they make from their taxes. This is why they are sometimes referred to as ‘Deductible IRAs’. If the contribution is $2,000, that person can deduct $2,000 from their taxable income.
Which is better?
The decision between the two has been long debated. Some financial planners suggest that the traditional is the best while others say go with the Roth. There really is no sure-fire right or wrong answer. It depends on several variables, what the market does and what participant’s tax rates are and what they expect them to be. For example, if you are in your ‘peak earning years’, typically your mid-40s according to many experts, there is compelling evidence for doing the traditional IRA since the tax deduction if the deduction is substantial.
But many agree that the Roth IRA is more flexible. The money could be taken out early, without penalty, if used for qualified educational purposes, if you become disabled or are a first-time home buyer. You can also withdraw the contributions (not the earnings and gains) at any point without penalty. Always check with your accountant or financial advisor to determine which is right for your particular situation.
Don’t forget, you may also be able to put the money into a self-directed IRA (either traditional or Roth). Here, you can have alternative investments which may not be correlated to the equity markets. These include real estate, raw land and precious metals. One negative regarding self-directed IRAs is that they don’t enjoy the same type of protections that traditional IRAs at conventional custodians do in case of failure (SIPC protection).
IRAs for Minors
If you have a child who is working, and also a minor, they can open up an IRA account but the child must have actual ‘earned income’ for the IRA will be in their name. For example, this may come from a paycheck at a job (like busing tables at a restaurant or scooping ice cream) but can also come from self-employed means such as babysitting, mowing lawns or shoveling snow.5
It used to be a little tricky to find an investment management company to open an account for your child, but that’s gotten easier over the years. An adult will need to be the guardian on the account since the child is a minor. Since the definition of a minor is different between states be sure and check applicable state laws and regulations.
A Roth IRA might be a good idea for a minor since the taxes paid up front should be small (presumably a small wage from a summer job and a small tax bracket) and the contributions grow tax free for as long as the account owner wants. If your child starts working a summer job in high school (say, age 14) and contributes part of that money to a Roth IRA, they could enjoy tax free growth on that contribution for decades until they retire. Assuming the investment earns 10.1% per year (the long-term average stock market return from 1926-2015)6 an initial investment of $5,500 (the maximum annual contribution for a minor) would grow to almost $744,000 if the person decides to retire at 65.
Of course, the Roth IRA contributions from the minor cannot exceed the amount earned, so if the minor earns only $1,000 over a certain year, the contribution can only be $1,000, not the full $5,500. Remember, you must designate the IRA as a “Roth IRA’ when you open the account. Getting your youngster interested in investing at a young age can put them on the right path towards financial success that lasts with them for a lifetime.
What Should You Buy in an IRA?
This article is not about picking specific investments or comparing one mutual fund company over another but there is one strategy that has proven effective- utilizing low cost funds and having a long time horizon. The empirical evidence is clear that lower costing investment funds (meaning lower “fees”) will earn substantially more than higher-cost funds over a long time horizon. While the markets are not controllable, your costs are. According to Vanguard, the fee on their “low-cost” fund, often an index fund, is 0.25% annually, while the average asset-weighted average expense ratio for a “higher-cost” U.S. stock mutual fund is 0.90%. This 0.65% annual difference between the two might not sound like much, but over a long time horizon can make a big difference on returns just by itself. Vanguard ran the numbers and if you invested a hypothetical $100,000 portfolio over a 30-year period with just a 6% average annual return for each fund, you’d have an extra $93,923 if you chose the low-cost fund over the higher cost-fund.7
Choosing to keep the money invested for longer, increases the power of compound interest, which Albert Einstein called the “most powerful force in the universe”.8 Another reason to adhere to the long-term horizon is that it’s the law. Again, you can’t withdraw money out until 59 ½ or you’ll incur a penalty from the IRS of 10% (not including the aforementioned allowable purposes). It should be noted that this penalty is on the earnings on the account, from capital appreciation and dividends. In the end, whichever decision you make on IRAs (traditional, Roth, education, self-directed, etc.) is the right decision because saving for your future is always a smart move.