I’ll be honest– when I landed my first job out of college and signed up for benefits through my employer, I had no idea what the difference was between an IRA and a 401(k).
All I knew was my employer set them up for me and only matched what I put into my 401(k), which was a nice perk.
But I kept hearing people talk about how wonderful this Roth IRA was and figured I would get to the bottom of these acronyms some other day.
That being said, I am now of the opinion that you should absolutely develop at least of working knowledge of any type of investment you own, no matter how passive it may be.
It is particularly important to understand your options as the anticipated age for retirement keeps creeping closer to 70 and our government-funded social security program is hemorrhaging at an unsustainable rate.
Intro to IRAs
IRA stands for Individual Retirement Account or Individual Retirement Arrangement. An IRA is an account that allows the owner to avoid capital gains taxes on investments and has many of the same restrictions as a 401(k).
The biggest difference between an IRA and a 401(k) is an IRA is an account that you can open yourself while the 401(k) is provided by your employer.
IRAs also allow more flexibility in investment options.
You can find the detailed rules regarding IRAs in the IRS’s publication 590. The rules around contributions are detailed in publication 590-a and the rules around distributions or withdrawals are in publication 590-b.
I’ll do my best in this post to pull out the most important items from these publications.
You can use your IRA to invest in stocks, bonds and other investments like real estate or businesses. Most large account providers allow only stocks and bonds, but you can find smaller providers who will allow you more flexibility in your investments.
The two types of IRAs intended for individuals are called Traditional IRAs and Roth IRAs. Let’s look at them both.
The contributions you make to a traditional IRA can be fully or partially tax deductible.
The amount you can deduct on taxes is determined by:
- whether you or your spouse have a retirement account provided by your employer
- how much money you make
If neither you or your spouse are covered by a retirement plan at work, you can deduct all your contributions.
If you are not covered by a retirement account, but your spouse is, then the amount you can deduct is dependent on your household income.
And if you are covered by a retirement account at work, then the amount you can deduct is again dependent on your household income, but there are much lower cutoffs for full and partial deductions.
Basically, you get the best terms for deductions if you and your spouse aren’t covered by a retirement account at work and the worst terms if your employer provides a retirement account for you already.
The other big thing to be aware of with traditional IRAs is that when you withdraw money from the account, it will be treated as taxable income for that tax year.
If you put $5,000 in your traditional IRA in 2003 and decide to withdraw $4,000 out of your account in 2020, then you will need to add $4,000 to your 2020 income tax documents.
One last thing.
You can’t keep your money in a traditional IRA forever. The law requires you to begin withdrawing money at a certain age, or you can be charged a 50% tax on your account.
The Roth IRA is identical to a traditional IRA except for 2 key differences.
While the traditional IRA offers deductions on contributions, the Roth IRA does not. Every dime you contribute to your Roth IRA will be added to your income taxes that year. So you pay taxes on those contributions the same year you make them.
That means that how your withdrawals are taxed is also different from a traditional IRA.
When you withdraw money from a Roth IRA, you will not need to add that money to your income tax statements for that year.
That means that withdrawals from Roth IRAs are not taxed!
Lastly, there is no requirement on distributions for Roth IRAs. You can leave your money untouched for as long as you want with no penalty.
Other IRA Rules
There are some other rules that your should be aware of that apply to both Traditional and Roth IRAs.
- There is a maximum amount you can contribute to these accounts in a year.
- Both plans allow payments you receive from your plan to be rolled over into another plan without claiming the payout as taxable income.
- You can, and should, assign a beneficiary to your IRAs in the case of your premature death. If you inherit an IRA there are some extra rules to be aware of.
- You may qualify for a $1,000 tax credit if you are putting money in an IRA.
Comparing Traditional and Roth IRAs
The natural question now is which type of account makes more sense?
You’ve probably heard advice that you should have a mixture of both. I disagree.
I strongly prefer the Roth IRA if your IRA is a big part of your retirement plan. The uncertainty of the tax landscape in the future really turns me off to traditional IRAs.
Today you can contribute to your Roth IRA for a tax rate of somewhere around 30% in the U.S.. Odds are very much against the tax rate in 10, 20 or 30 years being less than they are today. And it’s reasonable to think the rates could be higher.
If tax rates increase then you’ll be very glad to have paid the lower rates of the Roth IRA once you start taking distributions.
My personal advice is to go all in on the Roth IRA if you want to use the IRA as a retirement vehicle. Much more certainty in what retirement looks like for you when you don’t have to worry about taxation on withdrawals.
A self-directed IRA is an account that some financial institutions offer allowing a wider variety of investments.
The IRS doesn’t differentiate between “self-directed” IRAs and any other types. They simply list the types of assets that are disallowed from IRAs.
Collectibles and life insurance are not allowed. Here is the list of what qualifies as a collectible:
- Alcoholic Beverages
- Certain other tangible personal property
There is an exception for one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins minted by the Treasury Department. These can be held in an IRA.
In short, the IRS only says what you can’t invest in with your IRA.
The financial institution holding your account limits what you can invest in. Most institutions only allow stocks, bonds and mutual funds to be bought, but some institutions allow other investments like real estate or privately owned companies.
The flexible “self-directed” IRA can be right for those knowledgeable in a specialized field of investing. It comes with benefits and risks though.
If you are great at investing in real estate or know someone running a very profitable private business, then you should shop around for an IRA account custodian who will support that type of investment.
Finding the Right Institution For Your IRA
All IRAs must have a custodian to hold the account for you. Usually this is some sort of financial institution like a bank or a broker.
All the major investment service providers (Charles Schwab, Fidelity, E-Trade, etc.) will offer you traditional and Roth IRAs.
I would pay special attention to any management fees associated with those accounts when choosing an institution. If you’re not careful your account’s growth can be seriously hindered by high fees.
I would recommend looking locally for an institution to take on your alternative investments (self-directed IRA).
If you have a more actively managed investment, it’s often best to pair that with a personal relationship at your bank. Start calling banks and talking to real people.
Make sure you have your questions ready to go.
It usually doesn’t take long to start narrowing down your options.
Also, there are plenty of lists online that you can try. I prefer to have someone I can contact with questions, but sometimes with investing it comes down to numbers.
Never be afraid to shop around before making a decision.
Other Types of IRAs
Thus far I’ve only addressed traditional and Roth IRAs, but there are actually other types.
Employers can help their employees set up and fund their IRAs.
The biggest differences from the individually set up IRAs is that:
- Your employer sets up the account
- Your employer can contribute to the account
- These accounts have different contribution limits
- You can contribute to a traditional or Roth IRA without affecting contribution limits on your employer sponsored IRAs
A Simplified Employee Pension (SEP) IRA is set up by your employer for the purpose of contributing money to the account on your behalf.
This is a pretty unique plan because the employee doesn’t contribute anything! Only the employer can put money in this IRA.
The account itself behaves exactly like a traditional IRA when it comes to taxation of gains and withdrawals. But the rules surrounding contributions are quite a bit different.
The two big differences are:
- Only your employer can make contributions to this account
- Yearly contribution limits are significantly higher than traditional IRAs
SIMPLE stands for Savings Incentive Match Plan for Employees. It is also an IRA plan set up by your employer, and it looks a lot like the traditional 401k.
Your employer must contribute to your SIMPLE IRA either by matching 3% of your contributions or by putting 2% of your salary in by default.
Again the rules around contribution are a bit different from your traditional IRA, but the rules around withdrawals are the same.
Contribution limits are higher for the SIMPLE IRA than for the traditional IRA, but not nearly as high as the SEP plans.
An IRA is a capital gains tax-safe account that an individual can open for themselves. An employer can also create an IRA for their employees.
IRAs are intended to be held untouched until the retirement age and can be a meaningful part of a person’s retirement plan.
I recommend a Roth IRA if you intend to open an account for yourself as they offer more predictability in terms of taxation.
Traditional IRAs are arguably a better option for those would rather defer the income tax paid on their contributions to a later time.
Hopefully this article covered all the most important information but, if I haven’t answered your questions, the IRS lays out all the information you need regarding IRAs on their website.