Fun Fresh Finance

Gavin December 19, 2020

Beginner Guide to IRAs

An IRA, otherwise known as an Independent Retirement Account, is the only non-employer-sponsored retirement account available. Opening up an IRA should be one of your first priorities after filling up your rainy day fund. We all want to be saving up for our own place, but contributing to an IRA offers incredible tax benefits, and you want to start saving for retirement as early as possible. Part of the reason this is important is because IRA contributions are capped at $6000/yr per person, or $7000 for anyone age 50 or older.

Roth vs. Traditional IRA

There are two types of IRAs. Before contributing, you should decide which is right for you. In a traditional IRA, the amount that you contribute is deducted from your taxable income for the year of the contribution. For example, if you made a total of $40,000 in taxable income over the year but contributed $6000 to a traditional IRA, the $6000 will be deducted from your taxable income, lowering it to $34,000. This gives you an immediate benefit, namely more money in your pocket right now (from paying fewer taxes this year).

Roth IRAs work a little differently. When contributing to a Roth IRA your tax burden for the year of the contribution does not decrease. However, when you withdraw money from a Roth in retirement, all withdrawals are completely tax free. Conversely, when you begin withdrawing money from a traditional IRA in retirement you will pay income tax at the rate determined by your income in the year of the withdrawal.

Let’s walk through the same example of a year in which you have $40,000 in taxable income but make a $6000 Roth IRA contribution. You would pay taxes on all $40,000, leaving you with a higher immediate tax burden than if you had contributed to a traditional IRA. The main benefit doesn’t show up until you hit retirement age and begin withdrawing money from your (now substantially larger) Roth account and don’t have to pay any taxes on 40 years of gains.

When Can You Contribute?

In order to make contributions to an IRA for any given year, you must have “earned income”. That means taxable income which was paid to you by an employer or while self-employed. Money made off of stock gains, dividends, or rental properties can not be put into an IRA. If you have any kind of job where you are not declaring your income to the IRS (yard work, child care, tutoring, etc.) note that you will NOT be allowed to contribute to an IRA unless you are also receiving income which does qualify to the IRS as “earned income”. Keep in mind that these kinds of jobs can qualify as earned income, but to do so you must self-report the income to the IRS, and pay the taxes that come along with reporting that income.

It is very important to avoid excess IRA contributions, because every year that an excess contribution remains in your IRA the amount in excess will have a 6% penalty levied against you. If you make a $6000 contribution without having any earned income, all $6000 will be subject to the 6% penalty each year the money remains in the account. This would result in a $360 penalty the first year alone.

Roth IRA Withdrawal Rules

Sometimes bad times hit (like a global pandemic and accompanying recession), and your emergency fund just doesn’t cut it. Ideally, you want to wait until age 59 ½ to begin withdrawing from any kind of IRA. At this age and beyond you will be able to withdraw from a traditional IRA while paying income taxes on the money, or withdraw from a Roth IRA without owing any taxes.

If you need to withdraw money from a traditional IRA before age 59 ½, you will be charged a 10% penalty on whatever amount is withdrawn. If at all possible we want to avoid paying this penalty. One of the advantages of Roth IRAs is that early withdrawals on IRA contributions are allowed without any penalty. However, early withdrawals from investment earnings in a Roth account do have the 10% penalty assessed on them. To see this in action let's look at an example.

Say I’ve been working for four years, and have made the maximum contribution of $6,000/yr into a Roth account every year for a total of $24,000 contributed (note that this is not possible because 4 years ago the maximum contribution was only $5,500). Let’s also say that all of this money has been invested in a total stock market index and has collectively grown to $28,500 today. This amount represents $24,000 of contributions as well as $4500 of investment gains. At the age of 20-something, I would be able to withdraw up to $24,000 from my Roth account without needing to pay any kind of penalty. The second I withdraw $24,001, I will be charged $0.10, or 10% of the $1 of investment gains. If I were to withdraw the entire $28,500 I would have a penalty of $450, or 10% of $4500.

Roth IRA Income Limits

Another thing to keep in mind when choosing between a traditional IRA vs roth IRA is that there are roth IRA income limits. If you are single and have a modified adjusted gross income (MAGI) over $122,000 for the tax year of 2019, you are not eligible to make the full Roth IRA contribution. If you make over $137,000 you cannot contribute anything to a roth. The Roth income limit for those who are married filing jointly begins being phased out at MAGI of $193,000 and is fully phased out for those making over $203,000. If you land anywhere in the middle of these ranges you are able to contribute some non-zero amount less than the maximum.

The Roth IRA income limits beg the question: are there traditional IRA income limits? While the short answer is no, you can contribute to a traditional IRA regardless of how much you make in a given year, there are income thresholds above which you will no longer receive tax benefits for the IRA contribution. The majority of Americans, however, do not make nearly enough for this to apply.

How to Choose: Roth IRA vs Traditional IRA

It can be difficult figuring out which type of IRA is right for your specific needs. Since entering the workforce, I personally have worked relatively low wage jobs compared to what I hope to earn in the later parts of my career. Because of this, I have contributed to a Roth IRA each year rather than a traditional. I chose a Roth because my low income from teaching in a private school left me in a low tax bracket. My hope is that by the time I retire (likely in my sixties), I will have other investments which earn recurring income. If this turns out to be the case and I have a much higher income at that point, I will have paid fewer taxes on the same amount of income by choosing to pay them while in a lower tax bracket.

Of course there are other considerations, such as the opportunity cost of paying a certain amount in taxes in 2020 vs paying the same amount in taxes in 2050 or 2060. Money today is worth more than the same amount of money tomorrow due to factors such as inflation and the compounding power of investing. Opportunity cost refers to the lost opportunity of having that money immediately to use for things like investing or paying down debt. If I have $100 today, that’s better than $100 a year from now because that money could be invested over the year, growing larger than the original $100. Additionally, inflation is constantly devaluing money (to fairly small extents, in recent years typically <2%/yr), which means $1 today is worth more than $1 tomorrow.

For lower wage earners, a category which the majority of Americans fall into, Roth IRAs can seem like a more appealing choice because of their ability to double as an emergency fund. If you suddenly need to pull some money out of your Roth to pay rent or take care of a medical cost you are no worse off than if you had put the money into a savings account in the first place rather than a Roth. On the other hand if you need to pull money out of a traditional IRA before age 59 ½, you will have to pay an early withdrawal fee assessed at 10% of the amount you withdraw.

Not only can a Roth IRA double as an emergency fund (although I personally maintain a separate emergency fund so I do not need to pull from my Roth), it can also be used to help with a down payment on a house. Living in one of the most expensive housing markets in the country, it’s hard to imagine having enough for a 20% down payment. The reason I may not do this is because it is essentially borrowing against my future retirement. Anything I pull from my Roth today is money which will not be growing for the next 30 years.

As a general rule of thumb, I have decided that while young and making low wages I will contribute to a Roth IRA, and once I start making significantly more or get into my 40s, I will switch to contributing to a traditional IRA. Everyone’s situation is different, and it is important to consider your personal circumstances and finances when deciding between the two.