9 Surprising Advantages of IRA Plans
Why you should invest more in your IRA
|Written by Tom Yeung, CFA | CDFA
Investment Advisor & Fund Manager, Jurnex Financial Advisors
In a previous article, I wrote about the nine advantages of 401(k) plans. IRAs also deserve special mention. Why?
That’s because IRAs also have unique strengths that complement 401(k) plans.
Yes, I know. Saving money can be hard. And what’s more, IRAs aren’t automatically deducted from your salary like 401(k) contributions are. You have to contribute IRA savings yourself.
It’s like getting physical check-up: you *should* do it, and no one’s doing it for you. You have to schedule the appointment and do the legwork yourself.
IRAs are highly underrated
So in this article, I’d like to visit the nine surprising advantages of IRAs. I hope that these examples will help you better understand the importance of maxing out your IRAs every year.
What is an IRA?
IRA plans, also known as Individual Retirement Accounts, were established in 1974 to help people save for retirement. You still have to pay income taxes on contributions, but IRAs eliminate ALL capital gains and other taxes on investments, dividends, and profits.
There are two types of IRAs, giving you a choice on WHEN you pay your income taxes. This is one of many advantages of IRA plans that we’ll later discuss.
- Traditional IRA. Pay income taxes LATER. These accounts allow you to defer taxes until a later date. You pay no income taxes on contributions today, and only pay them (presumably in a lower tax-bracket) once you retire.
- Roth IRA. Pay income taxes NOW. These accounts allow you to eliminate all future taxes. You DO pay income taxes today, but all contributions never get taxed again. Roth IRAs have income restrictions at ~$130,000 annual income.
Generally, I recommend individuals with <$80,000 income focus on Roth IRAs and $>130,000 income on Traditional. People in between might consider a combination of both.
According to IRS rules, you can contribute up to $6,000 per year to your IRA as of 2019. This amount rises every year, typically by inflation. People who are age 50 or older also qualify for catch-up contributions, allowing an additional $1,000 contribution per year.
Your contributions can be divided between both types of IRAs, so long as the total amount comes to $6,000 or under. Contributing $4,000 to a Traditional account means you can still contribute the remaining $2,000 to a Roth IRA.
Employer-sponsored IRAs are known as SEP IRAs (Simplified Employee Pension) and SIMPLE IRAs (Savings Incentive Match Plan for Employees). These are similar to 401(k) plans since employers are responsible for their administration.
Why contribute to an IRA?
IRAs are one of the most potent retirement investment tools available. Someone maxing out their IRA at age 25 should have almost $2.2 million by the time they retire at 65!
As always, I suggest everyone talk to a qualified investment pro before making a final decision about retirement plans. That’s because saving for retirement is critical for your future self. It’s worthwhile to check in with a financial advisor first to make sure you’re on track.
However, to get you started, I’d like to share the nine surprising advantages of IRA plans.
The nine advantages of IRA Plans
Let’s take a look at the nine advantages of IRAs that you don’t want to miss.
1. IRAs are independent of employer policies
If your employer doesn’t offer a 401(k) plan, you can still invest in an IRA. That’s because IRA plans are individual retirement accounts. Virtually anyone who earns ordinary income can contribute.
How to open an IRA account?
I typically recommend my clients use a low-cost online brokerage to open their first IRA. That’s because online brokers offer a hassle-free online account management. You can see my reviews of the top four brokerages.
1. Open an account online or in-person
2. Deposit up to $6,000 into your IRA account using a money wire or check
3. Select your investments and buy them. See my article on creating a diversified stock portfolio
4. Report taxes to your accountant at the end of the year
5. Monitor your investments and rebalance as necessary
2. IRAs will always travel with you, regardless of your job.
IRAs are individual accounts, so changes in your employment doesn’t affect them.
- 401(k). Many companies will force a departing employee to withdraw their savings from the company plan. After that, the former employee has just 60 days to redeposit the money into a rollover IRA to avoid early-withdrawal penalties.
- IRA. For IRA accounts, none of this matters. That’s because IRAs are opened and owned in your name only. Even your spouse can only be named as a beneficiary, but not a co-owner.
Why does this matter?
IRAs simplify ownership issues. This matters in the case of divorce, widowing, and gifting. In some states, the spouse must provide written consent if the IRA contributor wishes to designate someone else as the beneficiary. But otherwise, ownership is entirely up to the account holder.
3. Easy to switch between Roth and Traditional contributions
One of the big questions I get is this: should I contribute to a Roth IRA or a Traditional IRA?
The answer is easy! My rule of thumb is as follow for annual income:
- <$80,000. 100% Roth IRA
- $80,000 – $130,000. A mix of Roth and Traditional
- >$130,000. 100% Traditional IRA
One of the advantages of IRA plans is how easy it is to switch between Roth and Traditional IRAs. When you make your annual investment, you simply tell the brokerage which way to designate the investment.
Roth IRAs have income restrictions
That’s important because Roth IRAs have specific income limits that prevent high earners from contributing. As of 2019, any single filer earning less than $122,000 modified adjusted gross income (MAGI) can contribute up to $6,000 to a Roth IRA. The amount phases out until a MAGI of $137,000. At which point, you can only contribute to a traditional IRA.
401(k) switching requires re-characterization.
On the other hand, 401(k) contributions are harder to switch. Employers deduct 401(k)s contributions whenever they pay your salary. So if you realize in December that you only qualify for a Traditional 401(k), you may have to recharacterize a full year of Roth 401(k) contributions.
4. The flexibility of choosing your broker
Here’s another of the advantages of IRA plans:
- IRA. You choose your broker.
- 401(k). Your employer chooses your broker.
Why is choosing your brokerage important?
If you’ve ever opened a bank account, you’ll know the difference between a great bank and an awful one.
- Great bank. You’ll walk in with a signed personal check and walk out just 20 minutes later with a zero-fee bank account under your belt, a free coffee in one hand, and a smile on your face.
- Awful bank. You might wait in line for an hour, only to find that the bank requires THREE forms of ID. You then leave and visit the bank above to open an account in 20 minutes.
The right brokerage account will make your life easier
The correct brokerage account can make an enormous difference. Not only are you looking for quality. You’re also looking for investment fit.
- Customer service. Many brokerage accounts offer 24/7 phone support in addition to physical branches. Others are online-only and might only provide chat without any phone support.
- Trading requirements. Some people want to trade the IRAs much more often. These people will need a high-quality, low-cost online (or mobile) trading platform.
- Range of products. Some brokerages offer US-only investments, while others offer international securities as well. Foreign investments can help diversification
5. Self-directed IRA
There is a myth about self-directed IRAs: they’re only for the adventurous, swashbuckling investor.
Let me tell you now: That can’t be further from the truth.
Self-directed IRAs give you flexibility
Self-directed IRA custodians hold your investments just like an online brokerage like Fidelity or Vanguard would. But instead of restricting you to stocks, bonds and funds, they will allow you to buy anything the IRS deems appropriate.
- Real estate (investment property)
- Raw land
- Mortgage notes
- Private Stock Offerings
- Limited Liability Companies (LLC’s)
- Tax Liens
Self-directed IRA custodians will generally tell you prohibited IRS transactions. These typically involve transactions the IRS deems “not appropriate long-term investments for retirement.”
- Collectibles. Includes artwork, collectible coins, and wine (i.e. things you can store in your basement)
- Non-retirement investments. Short options with an unlimited downside, life insurance
- Self-dealing. Buying assets from yourself or relatives
What are self-directed IRAs used for?
Typically, I recommend my clients use self-directed IRAs for real estate investing. That’s because you have plenty of opportunities to buy stocks and bonds in other tax-advantaged accounts. But with real estate, self-directed IRAs are typically the best way to shield them from taxes.
6. Flexibility in contribution timing
How do you know how much to contribute to your IRA? Here’s yet another of the advantages of IRA plans.
- IRA. Dollar amount decided AFTER the tax year ends.
- 401(k). Dollar amount decided BEFORE the tax year even begins!
So what’s the problem with 401(k) contributions? You need to decide how much you’ll contribute without much information.
Things happen. In some years, you might find yourself saddled with many one-time expenses. In those years, you can contribute LESS to your IRA account while you rebuild your cash reserves.
IRAs allow until tax day for you to contribute. That means an IRA contribution for the 2019 tax year only needs to be made before April 15th, 2020. Also, if your financial situation changes between December 2019 and April 2020, you can contribute not once, but TWICE in April 2020. Once for the 2019 year and once for the 2020 year.
In comparison, 401(k)s require you to decide beforehand how much you want to deduct from your salary. If you need the money later, the IRS will subject all withdrawals to the 10% penalty in addition to the 20% withholding tax.
7. You can withdraw, penalty-free, from your IRA for certain expenses
For the most part, early withdrawal from an IRA triggers a 10% penalty. However, IRS rules allow certain penalty-free IRA withdrawals.
- First home purchase. You can withdraw up to $10,000 from your IRA to cover the down payment of a house.
- Qualified higher education. The education expenses can be for you, your spouse, your children, or your grandchildren.
- Disability. The IRS allows penalty-free withdrawals from an IRA for people who are totally and permanently disabled.
- 60-day withdrawals. If you withdraw money from your IRA, you’re not charged a penalty as long to replace the borrowed money within 60 days.
8. A great tool to help your children start saving
You can set up an IRA for any dependent, no matter their age. And as long as they are earning some form of income, you can contribute that money on their behalf.
Good habits start early.
I like to tell my clients who have children: good habits start early. And consistent investing can be a great habit to teach.
If you have children, I highly recommend you help them open an IRA account. There’s a catch though: your children can only contribute up to their annual earned income. That means a teenager who makes $4,000 at a summer job can only contribute up to $4,000 to an IRA, not the $6,000 maximum.
Hire your children
To generate earned income, your children can work for you or friends. Fair market wages for mowing the lawn or fixing up the house all count. And once they have earned income, they can even contribute to their IRA using gifts from you (rather than earned income).
IRAs make great gifts
Because IRA contribution limits are relatively low, it pays to start contributing early.
Imagine using your IRA to buy some income-producing real estate. You might need 8-10 years of contributions to pay the $50,000 down payment. But if your child has been contributing since age 10, he or she might already have that amount by the time they leave college!
9. Tax-free investment growth
Many people are so focused on the Roth vs Traditional IRA debate that they forget about one of the biggest advantages of IRA plans: all your investments grow tax-free. That means no capital gains or dividend taxes on your IRA contributions. Ever.
That’s important because capital gains can range anywhere from 0 to 37%.
Regular investment accounts are subject to capital gains taxes.
- Short-term capital gains. If you buy and sell an asset within 12-months, you’re subject to short term capital gains taxes. Tax rates range from 10-37%, depending on your total taxable income.
- Long-term capital gains. If you hold an asset for longer than 12 months, the asset becomes eligible for long-term capital gains rates. Tax rates can range from 0-20%, though most investors find themselves paying 15-20% capital gains rates.
How much do taxes matter?
Starting with $10,000, an investor seeing an 8% growth rate over 35 years will have:
- Capital gains tax. $10,000 becomes $87,691
- No capital gains tax. $10,000 becomes $147,853
How do capital gains make such a difference? That’s the interesting thing about compound interest. The first case, the investments grow at only 8% * 80% = 6.4%. That means less interest in the first year, leading to less interest in the second year, and so on.
On the other hand, and investment growing a percent will grow faster and faster because the base gets more massive.
Conclusion: Will YOU take the advantages of IRA plans?
Now it’s time to put that knowledge to work! If you don’t have one yet, make sure you open an IRA account by the end of the tax year. And if you’re not sure where to start, don’t worry. The great news is you don’t have to do this alone. There are plenty of qualified retirement experts who understand the importance of investing your nest egg.
At this stage, I generally tell people not to worry about costs. It’s worthwhile to spend 3-4 hours with an investment pro today than make an investment mistake and not realize it for decades to come.
Where to find more resources
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