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rowynA long time ago, I said I'd do a piece on IRAs. I like IRAs even better than 401(k)s.
IRA stands for "Individual Retirement Account." There are two main types of IRAs: Roth IRAs, and traditional IRAs. I believe there are also IRA-like vehicles to allow people to save for college and medical expenses, but I'm not familiar with them so I won't get into that.
An IRA is a great way to lower your taxes, and isn't not paying taxes what finance is all about?
Roth and traditional IRAs lower your taxes in different ways, so I'll detail the tax benefits after I list the similarities.
Both kinds of IRAs are governed by the following rules:
--All you need to get one is an earned income. An IRA is your personal savings and doesn't involve any actions or decisions on the part of your employer (beyond paying you.) You can't contriubte more money for a year to an IRA than you earned in that year. (This may seem obvious to you, but part of the point is that you can't, say, transfer money from a non-retirement account into an IRA during a year that you have no earned income.)
--The maximum contribution to an IRA for 2002 and 2003 is $3,000. In 2004, it'll go up to $4,000 and is scheduled to stay at that level until Congress messes with it again. This is the maximum that you can contribute to any kind of IRA: you could put, say, $2000 into a tradtional IRA and $1000 into a Roth, but you couldn't put $3000 into a traditional AND $3000 into a Roth. If you do, the IRS will come for your kneecaps.
--You can contribute to an IRA for a given year anytime prior to April 15 of the following year. That means that, even if you didn't have an IRA in 2002, you can still put money into one now. You can make contributions for 2003 any time between Jan. 1, 2003, and April 15, 2004.
--You can open an IRA with any investment company that administers them. In practical terms, that means just about any bank, credit union, stockbroker, mutual fund, etc., in the nation. Everybody loves IRAs. You can invest in stock, bonds, or just a plain ol' savings account, if you like.
Ok, that's nice. Now what good does this do me, again?
On to the good part: lowering your taxes. We'll start with traditional IRAs.
Anyone with an earned income qualifies for a traditional IRA. Even if you are one of the Evil Rich People(tm) who makes more than a $100,000 a year, you qualify for a traditional IRA. This is true even if you're also participating in a 401(k).
However, if you do not participate in a 401(k), you qualify for the especially good kind of traditional IRA: your contributions to your IRA is tax-deductible. Even better, it's tax-deductible even if you don't itemize your deductions, so it's essentially piled on top of that standard deduction that most of us non-homeowners use.
If you do participate in a 401(k), you may still be eligible for a tax-deductible IRA if you are one of the Beloved Poor People(tm). Beloved Poor People(tm) are single people making less than $32,000 a yer, or married couples (filing jointly) making less than $52,000 a year. If you're single and making between $32,000 and $42,000, or part of a married couple with a combined income between $52,000 and $62,000, your IRA contribution is partially deductible. Consult the relevant part of the 1040 tax brochure to find out how much you can deduct.
Regardless of whether your IRA contribution is tax-deductible or not, your IRA will grow tax-deferred. Tax-defered is good because, instead of having a portion of what you earn on your savings go to the government every year, it'll stay in your account and continue to earn even more money for you. Yay! I cover the advantages of tax-deferral in a bit more detail in my entry on 401(k)s, and it works the same way for an IRA.
A traditional IRA has pretty much the same distribution requirements as a 401(k), so you can check that entry for info on getting your money back out again, too.
Finally, Roth IRAs.
Unlike a tradtional IRA, a Roth IRA is never tax-deductible. You also don't qualify for a Roth IRA if you make more than $95,000 a year (you Evil Rich Person(tm), you!)
But also unlike a traditional IRA, a Roth IRA isn't designed to be just tax-deferred: it's designed to be TAX-FREE! Woo-hoo! So if you don't qualify for a tax-deductible traditional IRA, but you're still under the income threshhold for a Roth IRA, you should always get a Roth instead of a traditional IRA.
If you qualify for a tax-deduction on a traditional IRA, deciding whether to get a Roth or a traditional one is trickier. For most people, a Roth IRA is going to be better than a traditional one.
Exceptions are:
--You have a high income now and plan to have a very low income when you are retired. If you're in, say, the 28% bracket now, but you figure to be at 10% or lower after retirement, getting the tax break now, when your taxes are high, may make more sense.
--You believe a tax-deduction in the hand is worth more than a mere promise of being tax-free down the line. While lots of people would be very pissed if the government changed the rules on Roth IRAs now, it's perfectly possible that they will. Dick Gephardt introduced legislation last year that would've made earnings on Roth IRAs taxable at distribution, same as traditional IRAs. Mind you, the bill didn't get anywhere, but it's still possible. On a more optimistic (and even less likely note), it's also possible that future income tax rates will be lower than current ones. As an extreme example: if income tax was replaced with a national sales tax, the tax advantages of a Roth IRA would vanish. So a Roth IRA is something of a bet that tax law is going to be much the same when you retire as it is now--or, if it's not the same, it will be because marginal tax rates have risen significantly, not fallen. That's a pretty safe bet, but it's still not certain.
Even if tax law does change, that doesn't mean getting an IRA, of whatever kind, isn't a good idea NOW. You'll get the advantages of tax-deferral today, no matter what changes in the future.
I, personally, have a traditional IRA. Even I would probably be better off with a Roth, but I'm addicted to that tax deduction.
The rules for withdrawing funds from a Roth IRA are basically the same as for withdrawing from a 401(k) or traditional IRA. However, Roth IRAs have an additional factor to bear in mind: earnings are only tax-free if you use them for a qualified distribution. So if you need to empty out your Roth IRA for a hardship, or before you turn 59.5 for whatever reason (other than first-time home purchase), there won't be any advantage to it having been a Roth rather than a traditional. (Though, since you've already paid taxes on the contribution to your Roth, you don't have to pay tax on that part regardless.) You also have to have your Roth IRA open at least 5 years before any earnings can be withdrawn tax-free.
One last note on Roths: some companies, at the least, will not open a brand-new Roth IRA account after Dec. 31 of the year for which you wanted it. So even though, right now, you can still CONTRIBUTE to a Roth IRA for 2002, you might not be able to OPEN one for 2002, if you don't already have one. I'm not sure if this is a government regulation, or a particular quirk of certain companies; I haven't looked into it closely yet. But it definitely isn't too late to start a 2002 traditional IRA.
IRA stands for "Individual Retirement Account." There are two main types of IRAs: Roth IRAs, and traditional IRAs. I believe there are also IRA-like vehicles to allow people to save for college and medical expenses, but I'm not familiar with them so I won't get into that.
An IRA is a great way to lower your taxes, and isn't not paying taxes what finance is all about?
Roth and traditional IRAs lower your taxes in different ways, so I'll detail the tax benefits after I list the similarities.
Both kinds of IRAs are governed by the following rules:
--All you need to get one is an earned income. An IRA is your personal savings and doesn't involve any actions or decisions on the part of your employer (beyond paying you.) You can't contriubte more money for a year to an IRA than you earned in that year. (This may seem obvious to you, but part of the point is that you can't, say, transfer money from a non-retirement account into an IRA during a year that you have no earned income.)
--The maximum contribution to an IRA for 2002 and 2003 is $3,000. In 2004, it'll go up to $4,000 and is scheduled to stay at that level until Congress messes with it again. This is the maximum that you can contribute to any kind of IRA: you could put, say, $2000 into a tradtional IRA and $1000 into a Roth, but you couldn't put $3000 into a traditional AND $3000 into a Roth. If you do, the IRS will come for your kneecaps.
--You can contribute to an IRA for a given year anytime prior to April 15 of the following year. That means that, even if you didn't have an IRA in 2002, you can still put money into one now. You can make contributions for 2003 any time between Jan. 1, 2003, and April 15, 2004.
--You can open an IRA with any investment company that administers them. In practical terms, that means just about any bank, credit union, stockbroker, mutual fund, etc., in the nation. Everybody loves IRAs. You can invest in stock, bonds, or just a plain ol' savings account, if you like.
Ok, that's nice. Now what good does this do me, again?
On to the good part: lowering your taxes. We'll start with traditional IRAs.
Anyone with an earned income qualifies for a traditional IRA. Even if you are one of the Evil Rich People(tm) who makes more than a $100,000 a year, you qualify for a traditional IRA. This is true even if you're also participating in a 401(k).
However, if you do not participate in a 401(k), you qualify for the especially good kind of traditional IRA: your contributions to your IRA is tax-deductible. Even better, it's tax-deductible even if you don't itemize your deductions, so it's essentially piled on top of that standard deduction that most of us non-homeowners use.
If you do participate in a 401(k), you may still be eligible for a tax-deductible IRA if you are one of the Beloved Poor People(tm). Beloved Poor People(tm) are single people making less than $32,000 a yer, or married couples (filing jointly) making less than $52,000 a year. If you're single and making between $32,000 and $42,000, or part of a married couple with a combined income between $52,000 and $62,000, your IRA contribution is partially deductible. Consult the relevant part of the 1040 tax brochure to find out how much you can deduct.
Regardless of whether your IRA contribution is tax-deductible or not, your IRA will grow tax-deferred. Tax-defered is good because, instead of having a portion of what you earn on your savings go to the government every year, it'll stay in your account and continue to earn even more money for you. Yay! I cover the advantages of tax-deferral in a bit more detail in my entry on 401(k)s, and it works the same way for an IRA.
A traditional IRA has pretty much the same distribution requirements as a 401(k), so you can check that entry for info on getting your money back out again, too.
Finally, Roth IRAs.
Unlike a tradtional IRA, a Roth IRA is never tax-deductible. You also don't qualify for a Roth IRA if you make more than $95,000 a year (you Evil Rich Person(tm), you!)
But also unlike a traditional IRA, a Roth IRA isn't designed to be just tax-deferred: it's designed to be TAX-FREE! Woo-hoo! So if you don't qualify for a tax-deductible traditional IRA, but you're still under the income threshhold for a Roth IRA, you should always get a Roth instead of a traditional IRA.
If you qualify for a tax-deduction on a traditional IRA, deciding whether to get a Roth or a traditional one is trickier. For most people, a Roth IRA is going to be better than a traditional one.
Exceptions are:
--You have a high income now and plan to have a very low income when you are retired. If you're in, say, the 28% bracket now, but you figure to be at 10% or lower after retirement, getting the tax break now, when your taxes are high, may make more sense.
--You believe a tax-deduction in the hand is worth more than a mere promise of being tax-free down the line. While lots of people would be very pissed if the government changed the rules on Roth IRAs now, it's perfectly possible that they will. Dick Gephardt introduced legislation last year that would've made earnings on Roth IRAs taxable at distribution, same as traditional IRAs. Mind you, the bill didn't get anywhere, but it's still possible. On a more optimistic (and even less likely note), it's also possible that future income tax rates will be lower than current ones. As an extreme example: if income tax was replaced with a national sales tax, the tax advantages of a Roth IRA would vanish. So a Roth IRA is something of a bet that tax law is going to be much the same when you retire as it is now--or, if it's not the same, it will be because marginal tax rates have risen significantly, not fallen. That's a pretty safe bet, but it's still not certain.
Even if tax law does change, that doesn't mean getting an IRA, of whatever kind, isn't a good idea NOW. You'll get the advantages of tax-deferral today, no matter what changes in the future.
I, personally, have a traditional IRA. Even I would probably be better off with a Roth, but I'm addicted to that tax deduction.
The rules for withdrawing funds from a Roth IRA are basically the same as for withdrawing from a 401(k) or traditional IRA. However, Roth IRAs have an additional factor to bear in mind: earnings are only tax-free if you use them for a qualified distribution. So if you need to empty out your Roth IRA for a hardship, or before you turn 59.5 for whatever reason (other than first-time home purchase), there won't be any advantage to it having been a Roth rather than a traditional. (Though, since you've already paid taxes on the contribution to your Roth, you don't have to pay tax on that part regardless.) You also have to have your Roth IRA open at least 5 years before any earnings can be withdrawn tax-free.
One last note on Roths: some companies, at the least, will not open a brand-new Roth IRA account after Dec. 31 of the year for which you wanted it. So even though, right now, you can still CONTRIBUTE to a Roth IRA for 2002, you might not be able to OPEN one for 2002, if you don't already have one. I'm not sure if this is a government regulation, or a particular quirk of certain companies; I haven't looked into it closely yet. But it definitely isn't too late to start a 2002 traditional IRA.
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This makes my head hurt...
Date: 2003-01-11 09:14 am (UTC)First: Retirement investing vs paying off debts
Date: 2003-01-11 02:08 pm (UTC)First, how low is a "low interest rate"? If you have a good credit history, you may be able to get a credit card at a "teaser" rate of 0 to 3%, and then just keep revolving your balance to a new card offering a "teaser" rate every six months, when the current card's teaser rate expires, until you finally have it paid off. If you are able to do this, or already are doing this, then I'd agree with Krudita: investing the money makes more sense than being in a hurry to pay off your debts.
If, however, "low interest rates" are more in the 8-15% range (which is low for a credit card but not low for anything else), then you might be better off paying down your debts.
I say MIGHT because paying off debts is NOT tax deductible, while contributing to a 403(b) is. Look at it this way:
Let's say you and Krudita have a top income tax bracket of 25%, and combined you make $40,000 a year. Between you, you have credit card debt of $10,000, at 10% interest. Krudita has the option of contributing money to a 403(b) stock fund.
Let's start assuming that you're not going to contribute any money to the 403(b). What happens? You pay federal and state taxes of $10,000.00. (you wouldn't, but the math is easier to follow like this). You spend $27,000. You use the remaining $3,000 to pay your credit-card debt. For simplicity's sake, we'll pretend that $3,000 pays principal. (It doesn't, and the reality of this is much harsher, but bear with me.) If you make this payment at the beginning of the year, than at the end of it, you'll have $7,700 in debt -- $7,000 of principal, and $700 of interest. You have no savings. Your net worth is -$7,700.00.
Now, what would happen if you contributed your spare cash to a 403(b) instead?
First, your taxable income will drop by whatever amount you put into the 403(b). In fact, you'll have $4,000 to put into the 403(b). $4,000 reduces your taxable income to $36,000, and 75% of 36,000 is $27,000 -- your total expenses for the year. (While this isn't accurate, in the sense that taxes are not done on a flat percentage for your entire income, it is more-or-less correct for figuring your gain by deducting, since the money you put into the 403(b) is money that you would be paying your top income tax rate on.) We'll say, again, that you put your $4,000 into a stock market fund. For the year, your stock fund manages to pull off a gain of 6%. At the end of the year, you'll have $4,240 of savings in a 403(b), and $11,000 in credit card debt. Your net worth is -$6,760.
So, even though your investment isn't paying you as much interest as the credit card is charging, you're still gaining net wealth.
Now, it's not QUITE this good, for a few reasons:
1) If you invest in the stock market, you won't be guaranteed any rate of return You could well lose money. The market has a historical average return of somewhere between 8% and 11% (I can't remember now and Google isn't helping me, for once), but the average return for the last three years has been negative. Strongly negative, in fact. (My personal rate of return on my investments, for the past 5 years combined, has been -3% per year. Yes, I'd've done better sticking it under my mattress. That's investing for you: there's risk involved.)
2) While you get a tax deduction for the 403(b) the year you put it in, eventually you will have to take it out again, and at that time, the government will tax you on it. But you will almost certainly benefit from a lower overall tax bracket. Your contributions over time will all come from the highest bracket you are in, but when you're withdrawing money, it will probably count as your whole income -- so some of it will be at lower tax rate or no tax rate -- just like your first $4000 of income is fully deductible under tax law now.
3) If you needed money right away, it would be cheaper to draw a credit card debt back up than to pay the early-withdrawal penalty for a 403b (which is 10%, plus you have to pay taxes on the money.)
Re: First: Retirement investing vs paying off debts
Second: 403(b)s
Date: 2003-01-11 02:09 pm (UTC)If you decide you don't like Krudita's investment options through the 403(b), but you do think the tax advantages make it more attractive than paying down your debt, then you can always get an IRA through the provider of your choice.
If you want more specific advice, based on, maybe, your ACTUAL finances instead of numbers I pulled out of my ... er ... hat, feel free to email me directly. :) I'm at the same email address still. I can leave it in your LJ if you've lost it. :)
Re: Second: 403(b)s
Date: 2003-02-12 09:52 pm (UTC)Another Type of IRA
Date: 2003-01-11 03:08 pm (UTC)This is actually a very big deal. Let's say that you invested in a bond fund earning 7% a year, and that you're paying about 40% in state and federal taxes on dividends/interest. For a $10,000 investment, if you let it sit 40 years in a non-deductible IRA, you would have $93,847 even after paying the taxes to withdraw the profits. In contrast, if you leave the money in a taxable account, paying 40% in taxes each year on your interest/dividends, then you would only have $51,845 after the 40 years.
This example magnifies the effect in 3 ways:
1) All of your earnings were fully taxable each year. If you bought and held an index fund for those 40 years, your interim taxes would be much lower since you don't have to pay capital gains taxes until you sell (or the mutual fund company sells on your behalf). Since most stock investors shuffle their money enough to pay a lot of capital gains taxes, though, this example isn't that unfair.
2) 40 years is a long time, although not a ridiculous length of time for a young person saving for retirement.
3) the investor is paying a high tax rate (although this is quite typical of people who are forced to use a non-deductible IRA).
On the other hand, the fact that the advantage of a non-deductible IRA is this large when Roth and traditional IRAs are much better still is telling.
Re: Another Type of IRA
Date: 2003-01-11 03:24 pm (UTC)