Taking Advantage of IRAs

With tax season here, it is a good time to consider IRAs. IRA stands for individual retirement account. They are a special type of account created by the government to encourage people to save by providing certain tax benefits. There are two types of accounts. One gives you a tax benefit now and the other gives you a tax benefit later.

Traditional IRA

In a traditional IRA, the government allows you to deduct the amount put into the IRA from the money you pay tax on. So if you owe tax on $50,000 for the year and put $4,000 in to a traditional IRA, the government would only tax you on $46,000. If you pay 30% taxes, that might be worth $1,200 to you.

Once the money goes into an IRA, you can’t take it out without paying penalties to the government. In addition to paying tax on the money when you take it out, you’ll pay an additional 10% penalty. There are certain provisions for hardship withdrawals that we won’t get into here.

When you retire and take money out of the IRA, you will pay tax on it then. Depending on your age there may be required to take a certain amount of money out each year.

Roth IRA

A Roth IRA is similar to a standard IRA, but it doesn’t give you the tax savings up front. You pay tax on all of your income now, but when you retire, you don’t have to pay any interest on the original amount (you already paid that tax) or on the amount it has grown. So if you put $4,000i into a Roth IRA and it grows to $12,000, you will pay the tax on the $4,000 up front, but you won’t have to pay any tax on the $8,000 in interest.

If you take an early withdrawal from a Roth IRA, you don’t have to pay tax or penalties on the original amount you put in. You do have to pay tax and penalties on any amount it has grown. The penalty is 10% just like it is for the Traditional IRA.

Exceptions

Certain exceptions may allow you to take money out of an IRA without paying the penalty. If you become disabled, have very large medical expenses, or if you use the money to purchase your first home you may be able to avoid the penalty.

Which Type of IRA

In general it makes sense to put money into a Roth when you are in a low tax bracket and a Traditional IRA when you are in a high tax bracket. Further, put money into a Roth when you expect it to grow significantly. Put money into a Traditional IRA when you need to shift the tax burden to a year that you will be in a lower tax bracket.

So following this advice a 20 year old with their first job would probably want to put as much into a Roth IRA as possible. This money will have the most time to grow and the 20 year old is probably not at the top of his salary curve. As the individual gets older it may make sense to switch to a traditional IRA. For example once the kids leave the house and no longer can count as dependents it might make sense to switch over to a Traditional IRA. This will probably happen when the individual is around 50. Also this money has less time to grow, so the future tax savings will not be as great. Also the individual is probably at the peak of the salary curve so it makes sense to try to minimize taxes now.

If an individual plans to make much more during retirement than now, it might make sense to stick with Roth IRAs the entire time.

One advantage of having both types of IRAs is that it gives you some flexibility to pull money from which ever one will have the least tax impact for that year. So during retirement you can take money out of the Traditional IRA when you have very little other income and your tax burden is low. You can take money out of the Roth IRA when you have a high income and don’t want to pay more taxes at your marginal rate.