It's IRA Season!

In the financial services industry, from now until April 15th is considered IRA season. This is because investors have until April 15th to contribute to an IRA for last year. With that in mind, I thought I’d spend a few minutes to discuss IRA’s.

IRA’s, or Individual Retirement Accounts, are accounts that an investor can establish as a retirement savings vehicle. An IRA is not an investment in itself, rather an account type or basket in which you can own stocks, bonds, mutual funds, cash, or several other investment types. The rate of return for your IRA is determined by the investments selected. So what is the value that an IRA brings to the investor? Mainly the tax benefits. There are 2 main types of IRA’s: Traditional and Roth. The differences in the 2 are mainly when the money gets taxed and who is eligible to contribute.

Traditional IRA

A Traditional IRA is basically pre-tax dollars that are allowed to grow tax deferred that are taxed upon withdrawal. Depending on income level and eligibility to participate in an employer sponsored retirement plan, when you make a contribution to a traditional IRA you are able to take a tax deduction for the amount contributed, up to $5500 ($6500 for savers over the age of 50). And if you are married, you may be able to double that by contributing for both spouses. The only limitations on eligibility for this deduction are first determined by whether or not you are eligible to contribute to a retirement plan through your employer. If your employer does not offer a plan, there is no income limit for the deduction. If you are covered by a plan at work:

Even if you are not eligible for the deduction, there may be some value in considering a non-deductible contribution to a traditional IRA. As stated previously, earnings within a traditional IRA accumulate tax deferred. So any interest, dividends or capital gains on your investments will not generate a 1099 and will not be subject to taxation as long as the assets remain inside of the IRA.

In exchange for the tax deferral, you must commit to keeping your assets in the IRA or at least within a comparable pre-tax retirement account until normal retirement age (at least 59 ½). If you need to take withdrawals prior to age 59 ½, your withdrawal will be subject to taxation at ordinary income tax rates plus an additional tax penalty of 10% of the withdrawn amount. There are couple of exceptions that allow for early withdrawals without the 10% penalty which should be discussed in the event that a withdrawal is needed.

For a saver who made a non-deductible contribution to an IRA, the earnings portion only of the distribution is taxed. Your original principal amount or contribution amount is withdrawn tax free, so it is important to keep record of this information through the years.

Upon reaching normal retirement age, once you decide that it is time to start taking withdrawals, you can do so. Withdrawals are taxed as ordinary income. If you continue to defer withdrawals, the IRS requires that you start taking withdrawals once you’ve reached age 70 ½. These withdrawals are called Required Minimum Distributions (RMD’s) and the amount required is based on an IRS published life expectancy table. The amount required by this calculation is a minimum withdrawal requirement for the year: you can take more if you wish, but must take at least this minimum amount. Some savers will take the minimum distribution once during the year; others will make periodic withdrawals throughout the year. The only requirement is that the minimum annual amount is withdrawn each year.

Roth IRA

The other alternative is a Roth IRA. The main difference between a Traditional IRA and a Roth IRA is when the money is taxed. A Roth IRA allows a saver to contribute up to $5500 ($6500 over the age of 50). No tax deduction is taken at the time of the contribution. Just like a Traditional IRA, the account grows tax deferred, so you won’t get taxed on your dividends, interest or capital gains while the money is invested in the account. Upon retirement, withdrawals are tax free. If you needed to take a withdrawal prior to age 59 ½, you would be taxed on your earnings only and also may be required to pay the additional 10% tax penalty. Again there are some exceptions that allow for early withdrawal without penalty that can be explored if the need arises.

Just like the Traditional IRA, a Roth IRA has some income limitations to consider for eligibility. There is no stipulation as to whether you are covered by an employer sponsored plan, anyone who is eligible to contribute based on income levels can contribute. Here is a breakdown of income eligibility limits for 2015:

Because normal withdrawals are tax free, the IRS has no bias to when you take withdrawals once you’ve reached the age of 59 ½. There are no Required Minimum Distributions.

Summary-Which is better?

So, in a nutshell: Traditional IRA is pre-tax (deductible) dollars that grow tax deferred and get taxed as ordinary income at retirement, Roth is after tax dollars (not deducted from taxable earnings) that grow tax deferred and can be withdrawn tax free at retirement.

There is no single right answer to which one is better. You have to consider your circumstances and what you are trying to accomplish to best decide which option works better for you. Things to consider are your current tax needs, your time horizon until retirement, your expected earnings now and at retirement, and eligibility. Working with a financial professional, you can get advice on which is better for your circumstances. Either way, there are good options available to get some tax advantaged savings at work for you while you accumulate a retirement nest egg.

Feel free to reach out to me to discuss your circumstances and what may be best for you.

***David Lockey, Lockey Wealth Management, and Fusion Capital Management are not tax advisors. Please consult with your tax advisor or CPA regarding questions pertaining to taxes.