Investing Advice

Traditional IRA

Our government has made it easy for anyone to begin saving, up to $3,000 each year using an IRA. The maximum amount is to be raised each year until 2008, when a worker can put away $5,000 each year.

Individual retirement accounts were authorized by congress in the late 1978. The idea is that you are encouraged to save pre-tax money now, beginning withdrawals at retirement and paying taxes then based on your expected lower tax bracket.

Investments qualifying for this special tax treatment include any type of securities, but not real estate or collectables. You designate which investments belong to your IRA, itís totally up to you. An IRA isnít really a special kind of account, but an IRS label for tax purposes.

In 1993, a new kind of IRA, the Roth IRA, was created. Savings in a Roth are done with after-tax earnings, but when you begin your withdrawals after you turn 59 Ĺ, there no taxes due on any of your investment. If your account has grown to $100,000 or $100 million, it doesnít matter Ė no taxes!

The principle disadvantage of a Roth is that if you retire in a significantly lower tax bracket, you will lose some of the tax benefits that you sought to gain.

This is why financial planners argue that a regular deductible IRA is still better than a Roth since you can initially save more, your initial tax liability is reduced, and the growth of your additional investments will then be more than enough to offset the future taxes.

In reality this just doesnít work this way. Iíll try to keep this example simple:

You contribute $3,000 to a standard IRA, and assume you are currently in the 23% tax bracket (after all standard deductions and credits) and will be in a 15% tax bracket at retirement. This will have saved you $840 in the current year, and in theory you should turn around and save this extra $840 too, tax-deferred. Assuming your IRA account grows at 12% a year for 20 years, you would have a total of $31,384 after all is said and done. The same $3,000 saved in a Roth IRA would only grow to a net $28,938 when you factor the lost potential of not having the extra $840 saved on this yearís taxes to also toss into the account.

But here is the fallacy:

  • You canít save the extra $840 tax-deferred because you are already at the limit. Since you would have spent the $840, the IRA grew to $24,599 after 15% in taxes. The Roth gave you another $4,338.

  • Letís be honest, even if you could put the $840 savings on your income taxes in the account, you probably wouldnít save it anyway.

Other disadvantages of a standard deductible IRA include

  • You canít take out any money early without paying a 10% penalty and taxes.

  • If your earnings keep you in a high tax bracket after retirement, you must still take minimum distributions at this high tax rate.

  • You canít pass the remainder of your account on to heirs tax-free, they will pay at their higher rate.

  • Income limits are rather low to qualify for standard IRA deposits, $70,000 a year if married, $40,000 if single. You can contribute to a Roth with an income up to $160,000 if married, and $110,000 if single.

  • If you also contribute to a 401(k), the income maximums are $50,000 and $30,000 when contributing to a deductible IRA.

  • Your retirement income tax bracket includes income from all sources including social security and all types of pensions.

So the bottom line is, choose a Roth IRA over a deductible IRA.

Other Retirement Planning Topics:

  1. Retirement Planning
  2. IRAís (Individual Retirement Account) Ė Traditional IRA
  3. Roth IRA Ė Taking Money Out
  4. Employer Sponsored Retirement Plans
  5. Retirement Plans - Continued
  6. 401K Savings
  7. Notes for 403(b) Plan Participants
  8. Senior citizens retirement resources
  9. Retirement Plans for Small Business and Sole Proprietors
  10. Simplified Employee Pension (SEP) IRAs
  11. SIMPLE (Savings Incentive Match Plan for Employees) IRA
  12. Your own 401(k) for the self-employed
  13. Employer Retirement Plan Vesting and Contribution
  14. Forgotten Retirement Benefits
  15. Other thoughts about retirement accounts
  16. Other thoughts about your retirement needs

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