Why an Individual Retirement Account is so beneficial

One of the most potent wealth generations tools is compound interest.  If you invest $6,000 in a retirement account today and let it grow at the average market return of 8%, it will be worth about $12,000 after 10 years.  After 20 years, it will be worth $26,000.

However, if you pay taxes on the gains, the total after 10 years is only $10,000 and after 20 years $20,000.  There are many assumptions built into this analysis, and your results will be different, but the point is that shielding your gains from taxes help build wealth.

The other factor to consider is avoiding paying taxes now, to gain from the money you would have otherwise paid as tax. You will pay taxes later, but you still get the time benefit of investing. Any money that you can invest rather than pay to the government will benefit you in the future.

There are limits

The contribution limit for Individual Retirement Accounts (IRAs) is $6,000 if you are under 50 years old and $7,000 if you are over 50 (this is different for a SEP IRA).  You can contribute throughout the year and up to the tax deadline for that year.  This means that you can make 2020 contributions through April 15, 2021.

This post goes through the various IRAs, how they work, and the contribution limits. This post is informational only and not advice; you should talk to your financial advisor or book some time to speak with us for more tailored information.

The IRAs that you can open and contribute to are:

The Traditional IRA is the original retirement account.

The government created these accounts in 1974 as a part of the Employee Retirement Income Security Act of 1974.  So they have been around for a while.

The Traditional IRA exists to allow people with earned income to save some of that income for retirement.

The advantages are avoiding paying tax now while earning interest, dividends, and capital gains tax-free over many years.

Additionally, if you are in a high tax bracket now, you may well be in a lower tax bracket in retirement.  Since you will pay tax based on your retirement tax bracket, you may pay less tax overall.

To contribute to an IRA, you must have earned income.  You can contribute up to the total of your earned income or the $6,000/$7,000 annual limit, whichever is less.

You can contribute to a Traditional IRA regardless of how much you earn, but there are some limits on deductibility if you participate in an employer-sponsored program. In this case, the deductibility of your contributions phases out when your income reaches $66,000 as an individual or $105,000 as a married couple.

There is a catch: there is a 10 percent early withdrawal penalty on distributions from the account made before you turn 59 ½.  (There are some exceptions to this. These including medical bills, buying a first house, and a few others. So, talk to a professional if you do need the money.)

Withdrawals are required after age 72, and at that point, you will pay taxes on the money you withdraw.

And then there is the Roth IRA

Congress created the Roth IRA in 1997 as a way to allow people to contribute to their retirement savings without reducing government tax revenues today.

From the perspective of the person saving, Roth IRA’s are attractive because the withdrawals are tax-free.  You pay tax on the money you contribute today, but you never pay tax on distributions.

The initial cost of paying the tax today can yield significant benefits later.  This is especially true if you have a longer time to invest or you think your tax bracket will be higher in retirement.  If you invest those $6,000 now and let that grow to $24,000 over twenty years, you will have $18,000 of tax-free gains.

Another advantage of the Roth IRA is there are no required minimum distributions.

You can leave your money in a Roth IRA until you need it.

Contribution limits are the same as a Traditional IRA: up to $6,000 if you are under 50, or up to $7,000 if you are over fifty.  (Note that these limits apply to your combined contributions: you can contribute up to $6,000/$7,000 in all accounts combined).

Like the Traditional IRA, you must have earned income; unlike the traditional IRA, there are income limits.  If you earn more than $125,000 as an individual ($198,000 as a couple), the allowable contribution decreases.  If you make more than $140,000 as an individual ($208,000 as a couple ), you cannot contribute directly to a Roth IRA.

However, you can easily get around these limits by contributing to a traditional IRA and then converting that account to a Roth IRA.  This adds a level of complexity, but any bank or brokerage offering IRAs will have a quick and easy way to make this conversion.

Remember that you will pay tax on the amount you contribute to or convert to a Roth IRA.  So, if your objective is to reduce taxes today while saving for retirement, contribute to a Traditional IRA.  The advantage of the Roth IRA are no taxes later and no required distributions.

Like the Traditional IRA, there are penalties for distributions if you take them before you reach 59 ½ years old.  Also, for the withdrawals to be tax-free, the account must be at least 5 years old.

The Self-Directed IRA is a Traditional IRA variant that gives you more control

Generally, a bank or brokerage will hold your IRA, and you will invest the money in stocks, bonds, or interest-bearing accounts.

A self-directed IRA allows you to make different types of investments.  Using a self-directed IRA, you can invest in alternative assets such as cryptocurrencies, precious metals, and real estate.

The contribution limits and eligibility are the same as a Traditional IRA.

The downside of a self-directed IRA is the risk.  But, if you know the risks and know what you are doing, this is a way to save for retirement using the investment strategies you prefer.

The SEP IRA – higher limits, employer (even self employed) sponsored

The SEP-IRA works like a Traditional IRA except that the employer contributes rather than the employee. This is great for small businesses and self-employed individuals.

The idea behind the SEP-IRAs is to encourage retirement benefits among businesses that would otherwise not set up employer-sponsored plans. Sole proprietors, partnerships, and corporations can all establish SEPs.

While the employer makes contributions, the employee decides how to invest the money and the account is managed by the bank or brokerage holding the account, so fees are low and there is little paperwork.

SEPs are great for small business owners because they allow you to invest significantly more in your retirement than a Traditional IRA.

As of 2020, the contribution limit is 25% of the employee’s compensation for the year or $57,000, whichever is less. That goes up to $58,000 in 2021.

You can also open and contribute to a SEP if you have a job where you earn a paycheck and a second business on the side. So, if you have some income from a business, you may want to consider opening a SEP.

Consider these accounts as a part of your tax planning

You still have time to make contributions for 2020.  You can make these contributions up until the tax deadline of April 15.  IRAs can be a great way to put the power of time and compound growth to work for you.

If you need help figuring out the implications of an IRA on your taxes or financial situation, we are here to help.

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