The IRA- A Retirement Account For (Almost) Everyone

Back when I first started putting money away in my IRA (individual retirement arrangement), I didn’t appreciate the fact that I could even open one. To be honest, I only opened one because I was highly encouraged to do so by Mr. RLDVM.

It was a reluctant choice. I was more worried about cash flow, and I really didn’t see the point in saving for retirement as a 20-something. Not only did it seem like a boring chore, it was also confusing because there was this thing called a Roth IRA, which was different from a traditional IRA. And then taxes were somehow in the mix. I had better things to do with my time than learn about retirement planning.

Well, hopefully after reading why you should think about retirement, you’re more enlightened about the subject than I was. I have already discussed the 401k, which is a workplace retirement account. IRA’s are a different retirement savings vehicle. As the name suggests, they are individual, meaning that you do not rely on a employer in order to open an account. Making the decision to open an IRA is completely up to you, and almost everyone is qualified to open one.

I will give a brief overview of both the traditional and Roth IRA. All of the numbers are for tax year 2020. This information is not meant to be comprehensive, because the rules can get hairy and I like to keep things simple. If you’d like to dig deeper, you can always find more information directly from the IRS website.

TRADITIONAL IRA: WHO CAN CONTRIBUTE?

If you are receiving taxable income, you can contribute. There is also no income limit, so billionaires could still contribute if they wanted to.

On the other end of the spectrum, there are those who don’t earn any income who can still contribute to an IRA. This is the case if you happen to be married to someone that has taxable income and you file your taxes married filing jointly, in which case the spouse can also have their own account (called the spousal IRA).

I could have theoretically opened an account as a high schooler, when I received my first paycheck from a dry cleaning business. And I could have continued contributing throughout college and vet school as I worked various jobs during the summers and the school year. However, due to my lack of knowledge about this subject, I didn’t start until I was working as a veterinarian.

As you can see, the IRA covers a broader pool of people than workplace retirement accounts.

TRADITIONAL IRA: HOW MUCH CAN I CONTRIBUTE?

In 2020, you can contribute up to $6,000. If you are age 50 or over, you can contribute an extra $1,000 as a catch-up contribution.

TRADITIONAL IRA: WHAT’S THE DEAL WITH TAXES? PART 1

It’s one thing to contribute. It’s another thing altogether when taxes come into the equation.

When you contribute to a traditional IRA, you will get a tax deduction depending on your modified adjusted gross income (MAGI). Your AGI, which is on your tax return, is usually similar to your MAGI. To calculate your MAGI, you can use this guide.

Remember, I said that anyone can contribute to a traditional IRA, regardless of income. But not everyone can get a tax deduction. You can get a tax deduction if you meet these criteria:

• If you have a workplace retirement account, you can receive a full tax deduction up to a MAGI of $65,000 if you’re filling single. If you’re married filing jointly, the full tax deduction can be taken up to a MAGI of $104,000.
• If your income is above these limits, then there is a phaseout, where you will receive a partial deduction. Then there is a point where you get no deduction at all (MAGI of $75,000 or more for single, MAGI of $124,000 or more for married filing jointly).

If you DO NOT have access to a workplace retirement account, then the rules change.

• If you’re single, or if you’re married and your spouse is not covered by a workplace plan, then there is no income limit- you can take your full deduction.
• If you’re married filing jointly with a spouse that is covered by a workplace plan, then the MAGI income limit is at $196,000 for a full deduction. There is no deduction after a MAGI of $206,000.

TRADITIONAL IRA: WHAT’S THE DEAL WITH TAXES? PART 2

Once you put money into your IRA, it grows tax-free. That’s why it’s called a tax-advantaged account. You will not get taxed until you start taking the money OUT of the account.

But please don’t use this account as a regular savings account, where you’re simply pulling money out whenever you want.

Similar to the 401(k) account, you will be penalized if you take your money out prior to age 59.5. There are a set of rules that will allow you to take the money out without penalty, but I hope you’re the type of person that will leave it alone, because you’re going to have a nice emergency fund to take care of emergency expenses, right?

After this magical age of 59.5, you can take the money out without penalty. However, that money will be taxed at your ordinary income tax rate because you already received a tax deduction way back when you made that contribution.

Starting at age 70.5, you will then be required to start taking money out of the account in the form of required minimum distributions (RMD).  Your RMD is determined by a formula. You will actually be penalized if you do not take your RMD.

As you can guess, there is all sorts of strategizing one can do in order to optimize your retirement withdrawals. You can DIY this, but I bet it wouldn’t be a bad idea to also work with a tax planner and/or a financial advisor.

THE ROTH IRA

I will fully admit, it took me forever to figure out the difference between a traditional and a Roth IRA. I had no context for these financial terms, and I kept forgetting which one was which, and why it even mattered. So for those of you that keep reading these financial terms and don’t find them intuitive, all I can say is that repetition is key. It’s just like learning a new language. It will eventually click.

Here’s the big concept you need to understand when it comes to traditional versus Roth IRA’s- it all has to do with WHEN you get taxed.

Remember, with the traditional IRA, you get that tax deduction up-front. Your money grows tax-free, then you are taxed when you start taking money out of the account.

With the Roth IRA, there is no tax deduction up-front. You are contributing with after-tax dollars, which means that you’ve already been taxed on this money. Your money grows tax-free, and because you paid the taxes up-front, you get to take your money out tax-free.

The desire to use this like a regular savings account is higher because you can make withdrawals whenever you’d like, penalty and tax-free (not including any gains to the account). As usual, there are a number of rules and regulations in place, which complicates matters. Like I said with the traditional IRA, better to leave this account alone and let the magic of compound interest work in your favor. Have an emergency fund and other savings vehicles to take care of unexpected expenses, rather than raiding your retirement account.

Traditional IRA: Tax deduction now, pay taxes later.

Roth IRA: Pay taxes now, pay no taxes later.

OK, now that we have that out of the way, let’s learn more about the Roth IRA.

ROTH IRA: WHO CAN CONTRIBUTE?

There is an income limit of $139,000 for filing single, $206,000 for married filing jointly.

ROTH IRA: HOW MUCH CAN I CONTRIBUTE?

The contribution limits are the same as the traditional IRA: $6,000 for tax year 2019, and you can contribute an extra $1,000 if you are age 50 or over.

Note: If you are contributing to both a traditional AND a Roth IRA in the same tax year, then the total between both accounts must be no more than $6,000 ($7,000 if age 50 or over).

ROTH IRA PERKS COMPARED TO THE TRADITIONAL IRA

• There is no RMD requirement with the Roth IRA.
• You can contribute regardless of whether or not you have a workplace retirement account, as long as you’re under that income cap.
• You can continue making contributions past age 70.5, unlike the traditional IRA, where you can no longer make contributions after that age.

Seeing all of these perks to the Roth IRA, it’s no wonder that this is a very attractive option for those that want to save for retirement. High earners, in particular, feel like they’re missing out because they get phased out of contributing to a Roth IRA due to the income cap.

THE BACKDOOR ROTH IRA

However, if you find yourself in this situation, there is still a way to get your money into a Roth IRA that is perfectly legal. It’s called the backdoor Roth IRA. To repeat, yes- this is legal.

In order to do this, you need to have a non-deductible IRA contribution. Remember how I said that anyone can contribute to a traditional IRA, but not everyone can get a tax deduction? Well, if you’re that high earner who contributed but cannot deduct your traditional IRA contribution, then you have a non-deductible IRA.

The very simplified version of how it works: You make a non-deductible contribution to your traditional IRA account. You then roll it over into your Roth IRA account. Voila- now you have money in your Roth IRA.

I could go on and on about the backdoor Roth IRA. But I won’t at the moment, because there are others that have gone above and beyond about this topic. The White Coat Investor has discussed this topic in great detail: click here for his comprehensive post about the backdoor Roth IRA. Despite the vast amount of information that is out there on how to do a backdoor Roth IRA properly, there have been a number of ways that this has been messed up by some very smart people. So please do your due diligence if you decide to go this route.

Physician on FIRE also has a great step-by-step on how to do a backdoor Roth IRA.

A RULE OF THUMB…

If you think that your tax rate is higher now and will be lower in retirement, then a traditional IRA makes sense.

If you think that your tax rate is lower now and will be higher in retirement, then a Roth IRA makes sense.

AND WHY I’M NOT A BIG FAN OF THESE RULES

Remember, we’re talking about retirement. If you’re not anywhere near retirement age, then these rules make less sense. We cannot predict with certainty what the tax brackets will look like decades into the future. Our own personal situations are also an unknown, as well as any other changes in legislation. As with investing, we can only make predictions based on what we know now.

Similar to investing, diversity is a good way to have some flexibility in the future. Many financial advisors recommend that you keep your retirement accounts in different buckets in order to increase flexibility when it comes to timing the withdrawal your money. Since many people rely on their workplace retirement accounts for retirement income, one could diversify by having a Roth IRA account that does not require RMD’s and is tax-free income. This is a decision that will ultimately depend on you, and if you so choose, a financial professional.

HOW TO GET STARTED, AND WHAT TO DO FROM THERE

You can open up both a traditional IRA and a Roth IRA at many financial institutions. A good starting point: the site Nerdwallet has a list that you can peruse at your convenience. There are pros and cons with each broker, so do your homework before making your decision.

Please refer to my 401(k) post to read up on how to invest your money in a retirement account. The nice thing about IRA’s is that they typically have more investment choices than a workplace retirement account.

If you have the ability to max out all of your retirement accounts, then do so. The IRA is just one tool, and hopefully you’re are saving much more than $6,000 every year for your future. If you want to get an idea of how much you’ll need for retirement, here’s a post about calculating your retirement number.

Have you diversified your retirement accounts? Comment below!