Trust Funds For Kids

    IRA and Roth IRA

    Published by

    Carl from Chicago

    on

    Overview

    An IRA (Individual Retirement Account) or a Roth IRA should be strongly considered if you are not eligible for an employer-sponsored retirement plan such as a 401(k) (for private employers) or a 403B Plan (or some other variant) if you work for a government or public sector entity (like a hospital or university). If you are eligible for an employer sponsored plan you still can make an IRA or Roth IRA deduction with certain income caveats and depending on whether your spouse is covered (if you are married filing jointly), but usually it makes more sense just to contribute to the employer plan (especially if they offer some sort of a “match” which most do).

    A traditional IRA plan gives you a tax deduction today (subject to income limits) BUT when you take out the money for retirement, the entire amount is taxable. A Roth IRA plan gives you no tax benefits when you make a contribution, but the entire amount is exempt from taxation when you make a distribution for retirement.

    Another advantage of the Roth IRA is that you can take out your contribution without penalty, but if you take out the amount above your contribution (let’s say more than $5000 in the example below) you will pay penalties.
    This article provides a nice simple overview of IRA’s and Roth IRA’s.

    The Roth IRA limits are $6500 for 2023 and $7000 for 2024.

    A Simple Comparison

    Let’s create a simple example. You deposit $5000 in an IRA when you are 30 years old, and it grows until you are 65 when you pull out the money. We will compare it with depositing $5000 in a Roth IRA when you are 30 years old and then taking out the money when you are 65.

    In this case we will assume that the $5000 grows at 7% / year compounded (annually) for 35 years in both the IRA and the Roth IRA example. In this case, your $5000 becomes $53,282.

    If your Federal tax bracket is 12% and you used an IRA you would save $5000 (your contribution amount) times 12% (your effective tax rate) = $60 in taxes in the current year. But when you pull that money out, you would likely be in a higher tax bracket (you’d be making more money then) so your $53,282 would be taxed at 24% (this is just a guess for illustration purposes) you are going to pay $12,787 in taxes 35 years from now.

    Thus it makes much more sense to avoid the current tax deduction for an IRA and just fund a Roth IRA, instead.

    Who Can Contribute

    You can contribute to an IRA or a Roth IRA if:

    • You are not eligible for an employer sponsored plan
    • You make less than a certain amount, which depends if you are single or married
    • You can still make a contribution even if you are covered, subject to some limits
    • Go here for the IRS contribution limits, It is easier than me attempting to explain them in a concise way

    What This Means in Practice

    Here is what this means in practice:

    • If you are eligible for a retirement plan from your employer and they offer any sort of match, you should contribute as much as possible to that plan. This will give you a current period tax deduction, as well
    • If you are not eligible for an employer plan, and you have any cash available, you should put it into a Roth IRA if you are younger and generally in a smaller tax bracket (24% or less)
    • There may be some odd cases where it makes sense due to a high tax bracket to put money in an IRA instead, but this would be rare because the high tax brackets are tied with income limits which phase out

    How To Invest in A Roth IRA

    If you set up your own Roth IRA, you can invest in it just like a brokerage account, meaning that you can use ETF’s, mutual funds, individual stocks, or cash. The best way to do it (limit complexity) is to set up this Roth IRA in the same brokerage account where you do your other investing.

    Timing

    For an IRA, generally if you do it by April 15 2024 you can do the deduction for the 2023 tax year. If you are putting money in a Roth IRA, however, the timing is irrelevant (there is no deadline). You just want to put your money in sooner so that it begins earning tax free and you can only put in $6500 in 2023 (or $7000 in 2024) so you want to understand the timing of when it occurs.

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