The Rationale Behind IRAs

It All Starts with The Need to Save for Retirement

IRA stands for Individual Retirement Account, and together with retirement accounts known as 401(k), this represents a large portion of the funds that Americans set aside to be used in retirement.

While we are working, we earn employment income, some of which we use for everyday spending and some we may set aside for future needs, some of which may be saved for retirement. Once we retire, we no longer have the benefit of the wages from working full time at least, as this is the definition of retirement, where one retires from full time employment essentially.

The Rationale Behind IRAsEven though we may receive pension income and may also continue to work part time, the expectation is that our income will decrease in retirement, at least the part that is earned from some sort of direct employment. To make up for this shortfall, we may get income from investments, or spend down part of the principal of what we’ve managed to accumulate in wealth to make up the gap.

This all requires us to set aside money for this purpose in the first place, unless we already have these funds, perhaps from an inheritance or given to us by members of our family. Most people do not have this already in place and therefore must save for retirement, lest they be forced to try to get by on the significantly smaller amount of money that they will be receiving once they do retire.

If one has neither the need nor the desire to save for retirement, retirement accounts would not serve the same purpose or need, but we still may want to take advantage of them for tax purposes. A Roth IRA in particular allows us to earn investment income without tax consequences, and therefore this is something that can be of benefit to just about anyone, even if they have plenty of money to be able to live out the life they want to for the rest of their lives.

It’s simply preferable to pay less tax though, no matter how much money you have, and even those who have incredible wealth already look to reduce their taxes whenever they can, although the income limits of IRAs do serve to be constraining. However, if the government willingly allows you to save on your taxes and even encourages you to do so, it makes a lot of sense to seek to benefit from the ability to do so.

Governments Seek to Make Taxation Fairer Through IRAs

It’s not really that important to think about why we get offered tax breaks on retirement savings, but when governments do offer tax savings, it usually does seek to serve a purpose that is important enough to them to go to the trouble of writing in these tax breaks.

In some cases, fairness may be the desired goal, and in others, there may be a benefit to both the individuals who fall under the scope of the rationale behind the tax break, and in turn, this may also be seen as good for the country overall.

We could say that both of these principles may apply to why we have IRAs, so let’s talk about the fairness principle first.

Given that income tax is progressive, we end up paying a higher percentage of our income in tax when we earn more and a lower percentage when our earnings go down. How fair progressive taxation ends up being seen as is a matter of some debate, and a matter outside this discussion, but since we do have it, we may want to seek to make it fairer.

We can view progressive taxation on purely a year over year perspective, where one’s annual income is the only thing considered, or we could look at this picture over multiple years and seek to define our tax rates over these longer periods of time, even one’s lifetime.

If someone makes, say, a million dollars in their lifetime, we could say that those who make this much over this amount of time should pay a certain percentage of it in tax, and those who make two or three million should pay higher percentages perhaps.

This would be a lot like how we treat capital gains and losses, where you can carry over capital losses to future taxation years to smooth out these cycles and seek to make the calculations more comprehensive and representative of what actually happened, even though the story occurred over multiple tax years.

The fact that we tally up our taxes annually is efficient but it also has its drawbacks. If someone made a lot of money one year and had their earnings drastically increased the next, progressive taxation would generally have the person paying more tax than if these incomes were averaged, and we really don’t have a way to deal with that properly.

We could ask ourselves why someone who made, say, $100,000 in one year and just $20,000 in the next should pay considerably more income tax than someone who earned $60,000 both years, even though the total income is identical.

We don’t use smoothing techniques to accommodate this particular problem, but when it comes to retirement, IRAs and other tax friendly retirement accounts actually seek to do this to a degree anyway, at least with retirements accounts that defer taxation of certain amounts of income to the future where one’s tax rate may be and often is lower.

This requires the perspective of looking at one’s tax contributions beyond the present and towards a cumulative amount. In doing so, we can take some of the bite out of progressive taxation and spread income out more in cases where income gets reduced by a significant amount and this becomes accounted for in one’s lifetime contributions to income tax.

There will be, of course, cases where one’s income does not decline in retirement, and in these cases, there is no smoothing involved. One’s fate here depends upon a number of things though, and very often there is at least some uncertainty about how well off we will be in retirement, how much our income may go down if at all, and a lot of this is dependent upon the performance of one’s investments.

By making the tax savings from traditional retirement accounts contingent upon one’s tax bracket being lowered in retirement, the government achieves its goal of greater fairness while not allowing those who do not merit this savings to receive it.

The Government Also Wants People to Save for Retirement

During our working years, we can be thought of as net contributors to government coffers, but once we retire, when we not only stop working but reach an age where we get paid out by social security and also qualify for health care subsidies, we take more out of the system than we contribute to it.

In a real sense, we go from taxpayers to those on social programs to some degree, and the government worries about how well this will all hold up in the future, and these concerns are very valid.

If social security payments become cut, perhaps drastically as some believe, or big cuts to Medicare become necessary, people will have to get by more on their own resources.

There are a lot of people, without the benefit of enough retirement savings, or in some cases none at all, that struggle financially under the current situation. If this should become worse, as it almost certainly will, this will cast even more of is into difficulty, and worsen difficulties as well.

The only real way to address this is to encourage us to save more for retirement, and in spite of many people doing a pretty good job of this, most of us should be doing more. By encouraging us to save more for retirement by offering tax incentives to do so, and also creating rules that will encourage us not to withdraw it early and do so in our retirement years, the government achieves the objective of looking to get us better situated and prepared for it than if these programs were not offered.

It is in the interests of both individuals and the country to have people well off in retirement, perhaps not as well off as they were in their working years, but reasonably well off nonetheless, in spite of the financial strains that ending one’s employment usually brings.

This will also better prepare them for any future shortcomings in the social fabric that helps them cope with this change, and if they are to rely more on their own resources to get by, a lot of people may not adjust to this enough themselves and providing them financial incentives like IRA accounts certainly can help them get on the right track more.

This Makes a Lot of Sense for Individuals as Well

It is natural to prefer the present to the future, and entirely reasonable to discount the future to some degree, but we don’t want to end up ignoring it either.

Saving money for anything can be a challenge for a lot of people, being driven to prefer to spend it now rather than save it for later, even though the pain of not saving can be quite a bit higher than the pleasure of spending it now.

We often tend to not weigh the future as much as we should and therefore discount it too much. A little of this makes sense, but not to the point of disregard. We tend to be far too focused upon the present and the near future, and something that may not be happening for decades can be more nebulous and therefore not receive proper attention.

A lot of people do plan for the future pretty well though, but a lot of people do not, with or without the benefit of the tax advantages of retirement accounts. A large percentage of Americans don’t have an IRA or a Roth IRA even though in the great majority of cases they should, from a financial perspective at least.

The goal here should be to view our finances more holistically, where what we spend today impacts what we will have to spend in the future, with the goal of seeking the appropriate amount of smoothing. We may not live that long, and this is sometimes used as an excuse by those who do not think of these things too deeply, but there is a high risk of that happening, and we need to prepare for it to happen.

There is a strong rationale therefore to want to save enough to take care of our retirement needs, or at least to seek the right amount of balance between our present situation and our future ones. Many people may not be able to save enough for retirement because most of their money goes towards basic needs and there may not be much left over, but this does not mean that we should not try and do our best.

IRAs can certainly help us achieve these goals by getting us on the right track, and by virtue of the rules surrounding them, help keep us there as well. We also benefit from the tax advantages themselves, either using the deferred tax amounts to receive compound gains with a traditional IRA, or to allow our gains to compound tax free in the case of a Roth IRA.

IRAs can be a valuable tool to help us achieve our retirement objectives, but they still require a strong commitment to the process of saving enough.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: robert@marketreview.com

Topics of interest: News & updates from the Federal Deposit Insurance Corporation, Retirement, Insurance, Mortgage & more.

The Rationale Behind IRAs

The Rationale Behind IRAs

It All Starts with The Need to Save for Retirement

IRA stands for Individual Retirement Account, and together with retirement accounts known as 401(k), this represents a large portion of the funds that Americans set aside to be used in retirement.

While we are working, we earn employment income, some of which we use for everyday spending and some we may set aside for future needs, some of which may be saved for retirement. Once we retire, we no longer have the benefit of the wages from working full time at least, as this is the definition of retirement, where one retires from full time employment essentially.

The Rationale Behind IRAsEven though we may receive pension income and may also continue to work part time, the expectation is that our income will decrease in retirement, at least the part that is earned from some sort of direct employment. To make up for this shortfall, we may get income from investments, or spend down part of the principal of what we’ve managed to accumulate in wealth to make up the gap.

This all requires us to set aside money for this purpose in the first place, unless we already have these funds, perhaps from an inheritance or given to us by members of our family. Most people do not have this already in place and therefore must save for retirement, lest they be forced to try to get by on the significantly smaller amount of money that they will be receiving once they do retire.

If one has neither the need nor the desire to save for retirement, retirement accounts would not serve the same purpose or need, but we still may want to take advantage of them for tax purposes. A Roth IRA in particular allows us to earn investment income without tax consequences, and therefore this is something that can be of benefit to just about anyone, even if they have plenty of money to be able to live out the life they want to for the rest of their lives.

It’s simply preferable to pay less tax though, no matter how much money you have, and even those who have incredible wealth already look to reduce their taxes whenever they can, although the income limits of IRAs do serve to be constraining. However, if the government willingly allows you to save on your taxes and even encourages you to do so, it makes a lot of sense to seek to benefit from the ability to do so.

Governments Seek to Make Taxation Fairer Through IRAs

It’s not really that important to think about why we get offered tax breaks on retirement savings, but when governments do offer tax savings, it usually does seek to serve a purpose that is important enough to them to go to the trouble of writing in these tax breaks.

In some cases, fairness may be the desired goal, and in others, there may be a benefit to both the individuals who fall under the scope of the rationale behind the tax break, and in turn, this may also be seen as good for the country overall.

We could say that both of these principles may apply to why we have IRAs, so let’s talk about the fairness principle first.

Given that income tax is progressive, we end up paying a higher percentage of our income in tax when we earn more and a lower percentage when our earnings go down. How fair progressive taxation ends up being seen as is a matter of some debate, and a matter outside this discussion, but since we do have it, we may want to seek to make it fairer.

We can view progressive taxation on purely a year over year perspective, where one’s annual income is the only thing considered, or we could look at this picture over multiple years and seek to define our tax rates over these longer periods of time, even one’s lifetime.

If someone makes, say, a million dollars in their lifetime, we could say that those who make this much over this amount of time should pay a certain percentage of it in tax, and those who make two or three million should pay higher percentages perhaps.

This would be a lot like how we treat capital gains and losses, where you can carry over capital losses to future taxation years to smooth out these cycles and seek to make the calculations more comprehensive and representative of what actually happened, even though the story occurred over multiple tax years.

The fact that we tally up our taxes annually is efficient but it also has its drawbacks. If someone made a lot of money one year and had their earnings drastically increased the next, progressive taxation would generally have the person paying more tax than if these incomes were averaged, and we really don’t have a way to deal with that properly.

We could ask ourselves why someone who made, say, $100,000 in one year and just $20,000 in the next should pay considerably more income tax than someone who earned $60,000 both years, even though the total income is identical.

We don’t use smoothing techniques to accommodate this particular problem, but when it comes to retirement, IRAs and other tax friendly retirement accounts actually seek to do this to a degree anyway, at least with retirements accounts that defer taxation of certain amounts of income to the future where one’s tax rate may be and often is lower.

This requires the perspective of looking at one’s tax contributions beyond the present and towards a cumulative amount. In doing so, we can take some of the bite out of progressive taxation and spread income out more in cases where income gets reduced by a significant amount and this becomes accounted for in one’s lifetime contributions to income tax.

There will be, of course, cases where one’s income does not decline in retirement, and in these cases, there is no smoothing involved. One’s fate here depends upon a number of things though, and very often there is at least some uncertainty about how well off we will be in retirement, how much our income may go down if at all, and a lot of this is dependent upon the performance of one’s investments.

By making the tax savings from traditional retirement accounts contingent upon one’s tax bracket being lowered in retirement, the government achieves its goal of greater fairness while not allowing those who do not merit this savings to receive it.

The Government Also Wants People to Save for Retirement

During our working years, we can be thought of as net contributors to government coffers, but once we retire, when we not only stop working but reach an age where we get paid out by social security and also qualify for health care subsidies, we take more out of the system than we contribute to it.

In a real sense, we go from taxpayers to those on social programs to some degree, and the government worries about how well this will all hold up in the future, and these concerns are very valid.

If social security payments become cut, perhaps drastically as some believe, or big cuts to Medicare become necessary, people will have to get by more on their own resources.

There are a lot of people, without the benefit of enough retirement savings, or in some cases none at all, that struggle financially under the current situation. If this should become worse, as it almost certainly will, this will cast even more of is into difficulty, and worsen difficulties as well.

The only real way to address this is to encourage us to save more for retirement, and in spite of many people doing a pretty good job of this, most of us should be doing more. By encouraging us to save more for retirement by offering tax incentives to do so, and also creating rules that will encourage us not to withdraw it early and do so in our retirement years, the government achieves the objective of looking to get us better situated and prepared for it than if these programs were not offered.

It is in the interests of both individuals and the country to have people well off in retirement, perhaps not as well off as they were in their working years, but reasonably well off nonetheless, in spite of the financial strains that ending one’s employment usually brings.

This will also better prepare them for any future shortcomings in the social fabric that helps them cope with this change, and if they are to rely more on their own resources to get by, a lot of people may not adjust to this enough themselves and providing them financial incentives like IRA accounts certainly can help them get on the right track more.

This Makes a Lot of Sense for Individuals as Well

It is natural to prefer the present to the future, and entirely reasonable to discount the future to some degree, but we don’t want to end up ignoring it either.

Saving money for anything can be a challenge for a lot of people, being driven to prefer to spend it now rather than save it for later, even though the pain of not saving can be quite a bit higher than the pleasure of spending it now.

We often tend to not weigh the future as much as we should and therefore discount it too much. A little of this makes sense, but not to the point of disregard. We tend to be far too focused upon the present and the near future, and something that may not be happening for decades can be more nebulous and therefore not receive proper attention.

A lot of people do plan for the future pretty well though, but a lot of people do not, with or without the benefit of the tax advantages of retirement accounts. A large percentage of Americans don’t have an IRA or a Roth IRA even though in the great majority of cases they should, from a financial perspective at least.

The goal here should be to view our finances more holistically, where what we spend today impacts what we will have to spend in the future, with the goal of seeking the appropriate amount of smoothing. We may not live that long, and this is sometimes used as an excuse by those who do not think of these things too deeply, but there is a high risk of that happening, and we need to prepare for it to happen.

There is a strong rationale therefore to want to save enough to take care of our retirement needs, or at least to seek the right amount of balance between our present situation and our future ones. Many people may not be able to save enough for retirement because most of their money goes towards basic needs and there may not be much left over, but this does not mean that we should not try and do our best.

IRAs can certainly help us achieve these goals by getting us on the right track, and by virtue of the rules surrounding them, help keep us there as well. We also benefit from the tax advantages themselves, either using the deferred tax amounts to receive compound gains with a traditional IRA, or to allow our gains to compound tax free in the case of a Roth IRA.

IRAs can be a valuable tool to help us achieve our retirement objectives, but they still require a strong commitment to the process of saving enough.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: robert@marketreview.com

Topics of interest: News & updates from the Federal Deposit Insurance Corporation, Retirement, Insurance, Mortgage & more.