IRA = Individual Retirement Account.
ROTH IRA and Traditional IRA.
| Regularly-Taxed Account | Traditional Deductible IRA | Roth IRA |
| You pay income tax, and then make your contribution with post-tax dollars Your principal may be subject to taxes on dividends and capital gains as it grows You pay capital gains tax on your gain at withdrawal | You get a tax deduction, essentially letting you deposit pre-tax dollars Your principal grows tax-free You pay income tax on the entire amount of your withdrawal | You pay income tax, and then make your contribution with post-tax dollars Your principal grows tax-free You pay no further taxes on withdrawal. |
Scenario1: You earn money. You pay taxes on them based on your tax bracket. You invest a portion of the remaining money in Stocks or Mutual Funds. The value of your portfolio goes up and you pay taxes again on the capital gains. You pay 15% if the stocks were held for a year or more or tax percentage equivalent to your tax bracket if you held the securities for less than a year. Either way, you pay taxes on your income and then again when you invested a part of that income to earn capital gains. Its like double taxation!! Avoid this!
Example: You earn $48,000/year. After paying taxes, your take home pay is $38,000. You invest $8000 in the stock market and you make $1000. You pay taxes again on that $1000 profit. Not only did you pay tax on your salary once, but you also paid taxes again when you invested that same post tax dollars.
Scenario2: Traditional IRA - You set aside certain amount of money (subject to annual limits) of your paycheck in this account. You don't pay any taxes on this amount right now thereby reducing the pool of money in the "higher tax bracket". You can invest that money in stocks or mutual funds and let that pool grow every year. When you are ready to retire you pay taxes on the total amount (contributions + earnings). Depending on how much you take out you pay taxes on that much amount only. The idea is you reduce your current tax liability, your money will grow and in the future your tax bracket would be much less depending on how much you take out every year and so you pay less taxes. Also, since the money grows without taking out the tax up front, the amount is also more and the more the amount, the more it grows thanks to compounding and reinvestments. There are penalties and taxes if you try to get your money before retirement.
Example: You earn $80k/year. You set aside $5000 every year for 30 years into traditional IRA account. Keep in mind that exact $5000 without taking any tax out goes to your account. This money is invested into the market and even if it earns 3-4% this amount will grow to $291,000!! using compounding interest. You pay taxes on this amount depending on how much you take out every year.
Remember, the entire amount will be not be charged a flat %. Tax brackets are tricky, if not understood well; check this link for more information on your bracket.
For 2009, income between 16,700 and 67,900 is charged at 15% and 67,900 and 137,050 is charged at 25%.
Current federal tax without IRA drop:
(1-16,700 ----10%) + (16,700-67,900---15%)+ (67,900-75,000---25%) = $10,872
With IRA drop:
(1-16,700 ----10%) + (16,700-67,900---15%)+ (67,900-75,000---25%)= $9622
Rather than pay 25% tax on income from 67,900-80,000 you pay 25% tax on 67,900-75,000.
Future:
if you withdraw only $67,000/year you will pay only 10% tax on 16,700 and 15% tax on the $50,300. You don't even care about the ridiculous 25% bracket at this point.
Foolish Bottomline: Most people with incomes above $60k don't qualify for traditional IRA making it pretty useless. Otherwise, the quick and easy withdrawal for valid reasons and no holding period make it very attractive.
Scenario3: Roth IRA - The best choice in my opinion. You pay taxes on your income. You invest a portion of the remaining money into a ROTH IRA account ( 5000/person or 10,000/couple). That's it! You are done with taxes. The money in that account grows (stocks and bonds) and grows and lets say it quadruples. You pay nothing extra since you already paid taxes. Nothing nada. Even if you contribute $5k/year and it ends up being a million dollars you will still not pay a penny to the IRS. Penalties for early withdrawal still may apply. The Roth IRA income limits for 2009 are $176,000 for married filing joint taxpayers, and $120,000 for single taxpayers. If your income is within this range, you can still contribute a max of just $5000/person or $10,000/couple per year.
Read more: Current Contribution limits
Example: You make $80k/year. You pay taxes upfront. You don't reduce your tax liability, but the biggest advantage is that in the future when you retire you don't pay a single penny in taxes again. You are done with paying taxes on principal, but you basically bail out or skip paying any taxes on the earnings that you get by compounding and investing. So yeah no upfront reduction in tax liability like the traditional IRA by reducing the pool of money in higher brackets, but then virtually no more taxes on an infinite amount of earnings.
The contributions can always be taken out tax free and penalty free at any time for any reason.
Why would I want to contribute to IRA when I have current needs like buying a house and a fancy car?
The money you contribute to IRA has serious tax implications. All wealthy people know that paying 35+% in taxes ain't making you richer. Irrespective of your IRA choice, you have tax advantages: You don't pay any taxes on capital gains via ROTH; With tradition IRA, your upfront investment is more +& you reduce your current tax liability.
What is a qualified distribution and a non-qualified distribution?
A qualified distribution is one in which you withdraw money from ROTH IRA
- You are disabled
- You want the money to buy a house as a first time home buyer (limit of $10,000/person or $20,000/couple).
- Are used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members. (This is where you can benefit if you decide to get your MBA from your own pocket)
- You are 59+ years old
However, if you are borrowing in less than 5 year mandatory period, you will pay taxes on earnings despite being a qualified distribution.
If it is a non-qualified distribution, you will pay early withdrawal penalty (10%) and taxes on the earnings.
An often-overlooked benefit of the Roth IRA is that the tax free distributions from the account don't count against income in the calculation of taxable Social Security benefits
Assuming you graduate from college at 22, if you plan to buy a house when you are 29, you need to make sure you start contributing to ROTH IRA in the year before you turn 24. So if you plan to buy a house in the next year or two, then you should forget taking the money out unless if you get disabled. However, the idea of money growing without paying taxes is something you shouldn't ignore.
Foolish Bottomline: Income limits are higher and as long as you are under 150k you can contribute to ROTH IRA. However, if you take out money before retirement you will pay taxes again (double taxation) even if you avoid the penalty. Plus the 5 year waiting period no matter what! Sucks!
How do I get started?
E*trade has one of the best no fee IRA:
- No hidden fees: no opening, closing, annual or custodian fees
- Self-direction - no minimum annual contribution, and you choose your investment vehicles
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