IRAs Allow You To Defer Tax Payable
Individual Retirement Accounts, or IRAs, is a retirement plan available to residents of the United States. The goal is to help people accumulate wealth in retirement, at a time where their income generally drops, placing them in a lower tax bracket.
There are two main types of IRA accounts, what is called a traditional IRA, which defers tax on contributions, and a Roth IRA, a fairly new type of IRA which doesn’t defer taxation on the principal. We’ll start out by speaking of traditional IRAs and then move on to Roth IRAs a little later in the discussion.
So the rationale behind traditional IRAs is that if you are saving a certain amount for retirement, and this is when you will be spending it, you should be able to pay the taxation rate on this money at the time you’ll be using it, not the tax rate that you would pay now while you are saving it.
All income is normally subject to taxation, and this money is as well, and what people do with a traditional IRA is postpone paying income tax on it until it is cashed in. In the meantime, it is held in a registered account by an authorized financial institution and is subject to the rules and regulations of the Internal Revenue Service.
So in doing so it treats this money cashed in during retirement as income that is earned during that time. So for instance if the tax rate on your contributions today was 20%, instead of paying that 20%, you would pay no tax right now. When you retire, presuming that you would be in a lower tax bracket, or at least not in a higher one, you stand to benefit.
Even if your marginal tax rate has not changed in retirement, meaning that you aren’t making significantly less money and your income is such that the tax you end up paying on your IRA distributions is the same as you would have paid, you still benefit from the arrangement.
If your income is greater, to the extent that you are in a higher tax bracket, then using the IRA isn’t going to be a good choice at all, as this will have you paying more tax in the end. However, you still would benefit from holding on to this tax money for all those years, which would at least offset some of this additional tax paid.
Few of us are fortunate enough to have our income in retirement bump us up to a higher tax bracket than the one we were in while working, so this isn’t something people really worry about. We still need to be aware of the possibility though so that if this becomes likely, we may look to reduce or eliminate our traditional IRA contributions so that they don’t end up leading to paying more tax instead of the less tax that this program is designed to allow for.
Traditional IRAs Involve Investing Borrowed Money from the IRS
Contributions to IRAs can be made either pre tax or post tax. If they are made pre tax, the tax simply is not remitted. If they are made post tax, the tax you paid on the contributions. In both cases though, the result is the same, not paying tax on the contributed amount.
If you contribute pre tax, that’s fine, but one of the real benefits of a traditional IRA isn’t as apparent as when you contribute post tax, where it’s easier to see your tax savings as this will either reduce the amount of tax you have to pay, or increase the amount of your tax refund.
This serves to make one of the real benefits of a tax deferred savings vehicle more transparent, and that benefit is getting the tax money back to be used for the benefit of the taxpayer.
So whether or not this amount is contributed to the tax investment account or not, one may invest that money and get a return on it over time. In a real sense this involves borrowing this money from the government, interest free, to be paid back at a later date, when the principal amount, although when the contribution is made pre tax this is not as clear.
Let’s say you invest $5000 into an IRA, pre tax. We’ll use the simple example of a 20% tax rate, so that’s $1000 that you didn’t have to pay in tax. Compared to not investing in the IRA, you would have invested $4000 in something, but you do have $5000 in the IRA, an extra $1000.
This is the money that you would have paid in tax now if not for the IRA. This money sits in your IRA until it is withdrawn, which may be years or even decades, growing along with the rest of your investments.
So this really does amount to borrowing money from the government and using this borrowed money, an interest free loan in fact, and one that one typically pays back less than was borrowed in the end.
With a Roth IRA, contributions are not tax deductible, like they are with traditional IRAs, and instead, the distributions are not taxable, regardless of what tax bracket you are in when you cash in the proceeds from it.
Roth IRAs came into effect in 1997, and are named after Senator William Roth of Delaware. Money contributed to a Roth IRA is already taxed, so there is no further tax payable on it, and in this sense it functions like any other investment account.
However, money earned on non registered investments is taxable, and this is where a Roth IRA can save you a bunch of money on taxes, because the investment grows tax free, no matter how much money it makes.
As it turns out, both types of IRAs yield similar investment benefits. If you compare the savings on tax of the increase in value of a Roth IRA with a similar return on the deferred tax on a traditional IRA, they work out to be the same.
So this ends up coming down to the tax savings on the contributions of a traditional IRA versus the tax savings on the earned income of a Roth IRA, and generally speaking, if one’s tax bracket drops, the traditional IRA will yield better results, but if it does not, the Roth IRA will win out every time.
So for a lot of people, those who expect a significant drop in income at retirement, the traditional IRA is still going to be the sounder of the two for them. However, a lot of people have the goal of not seeing their retirement income drop very much, if at all, so if one is successful in doing this, then Roth IRAs can be a sound choice, since they do better in these circumstances.
IRA Eligibility and Contribution Limits
Since IRA stands for individual retirement account, one does contribute to it individually, as opposed to employee sponsored contribution plans such as the 401(k) or a pension plan. When deciding the contribution limits for IRAs, the IRS does consider both one’s income level and one’s participation in employee plans.
The maximum current contribution limit for IRAs is $5500 per year if one is under 50, and $6500 for those over 50. This applies to both traditional and Roth IRA contributions, and the maximum is the total combined amount.,
For those who do not have a retirement plan through their employer, they are eligible to contribute up to this amount in a traditional IRA. For those who do have an employee plan and who earn between $61,000 and $71,000, only a portion of their contributions are tax deductible, and for those who make over $71,000, their IRA contributions are not tax deductible.
It doesn’t make any sense at all to contribute to a traditional IRA without the benefits of having the contributions tax deductible though, as this is the only reason to contribute to an IRA over just investing the money in non registered accounts.
Roth IRAs do have income qualifications, but they are higher than ones used for traditional IRAs, with the maximum currently set at $132,000 for single filers and $194,000 as household income for joint filers. So for those who cannot realize the full benefits of a traditional IRA, they may still be able to enjoy the benefits of a Roth IRA, provided their income is beneath the maximum threshold.
One may also contribute to a spousal IRA, which is a great program for those whose spouse has little or no income. The idea here is that provided the spouse is in a lower tax bracket than you are in retirement, you can save even more on the taxes due.
One can contribute to an individual IRA up until age 70 ½, where with Roth IRAs there are no age restrictions. It is assumed that at this age though there really should not be a need for tax deferral, and this is generally true.
In order to withdraw from a traditional IRA without a penalty, you generally have to be at least 59 ½ years or older, although there are some exceptions. This can serve to motivate people to stay the course though, as the early withdrawal penalty can serve as a deterrent.
With Roth IRAs, you can take the money out anytime, although certain conditions need to be met to take it out and keeping the tax advantage on the distributions, including being over 59 ½. So once again, these investment vehicles do provide a nice incentive to stay the course.
IRAs are a great way to save for retirement, and one can choose from all of the popular investments, other than speculative ones such as options and currencies. It’s not that you can’t trade in these things, it’s just that you can’t do it with your IRA account.
So with the significant tax benefits that are possible with IRAs, people who are saving for retirement that live in the United States need to ensure that they are taking full advantages of whatever opportunities are present with them.