What is an IRA & Why Everyone Should Have It

A shocking 21% of Americans have nothing saved for retirement, and even fewer have an IRA. We’ll explain what is an IRA, and why everybody in the United States should have one.

What is an IRA?

An individual retirement account, or IRA, is an account that you can set up at a brokerage firm or financial institution. It can be set up in just a few minutes, and most brokerages offer them for free.

We’ll get into the advantages from IRAs, and walkthrough the different options you have.

IRA Benefits

The main benefit of an IRA is the deferred tax savings. Any money will grow tax free, regardless of investments you sell and dividends you receive. In a normal brokerage account, you could be subject to capital gains or income tax for stock sales and dividends you receive.

All of this money will grow tax free until you withdraw the funds.

Traditional IRAs allow you to deduct your contributions depending on your income. As of 2018, you can deduct all of your contributions if you make less than $63,000. If you make more than $73,000, you cannot deduct any of your contributions.

Traditional IRA vs Roth IRA

There are two types of IRAs: traditional and Roth. The main difference between them is how they are treated for taxes.

Traditional IRA

Traditional IRAs give you the ability to deduct your contribution as long as your income is under a certain threshold. (under $73,000 in 2018). In doing so, you’ll save taxes now, and will pay taxes for the withdrawal later.

Traditional IRAs are a great choice if your current tax rate will be more than your tax rate at retirement. Since income taxes are marginal and go up with your income, you’ll likely be at a lower tax bracket when you retire and have less income.

Roth IRA

Roth IRA contributions are made with after tax dollars, meaning that they will not be deducted from your income. By paying your taxes now, you won’t have to pay any taxes when you withdraw the funds at retirement.

Roths are a no-brainer for people who will pay higher taxes at retirement, but that is a very select group of people. Only incredibly affluent people will be at a higher tax bracket after retiring and giving up their primary salary. Therefore, for most of us, Roth may not be the way to go.

Roths have certain eligibility requirements as well. Only people who make less than $135,000 can contribute to a Roth. Since 92% of the United States makes less than $135,000, most of us will be covered.

This brings up another point, if you make more than $73,000 and less than $135,000, then you should definitely contribute to a Roth. You won’t get any income tax deductions by contributing to your traditional IRA, and socking the money in a Roth will ensure you withdraw the money tax-free when at retirement.

Converting a Traditional IRA to a Roth

Another consideration to make is converting some of your traditional IRA to a Roth. Any money you convert from your traditional IRA to your Roth will be taxed now, and will ensure that you owe no taxes on withdrawal. Anybody can make this conversion – there are no income limits or eligibility requirements.

If you are relatively young, or have a down year in income. Converting some of your traditional to a Roth could save you a ton in taxes in the future. Fidelity has a terrible calculator to show the benefits and drawbacks of converting some of your traditional to a Roth.

You do not have to convert all of your traditional either. In fact, we recommend handling the conversion in tranches.

Suppose you have $20,000 in your traditional IRA. We recommend opening a new Roth (most brokerage companies give you as many as you want for free) and converting $4,000 to this new account. This way you are dollar cost averaging your taxes, and are accounting for drops or changes in the market.

What is an IRA – The Bottom Line

Now that you know what is an IRA, and know that having one is free, we hope your next move will be to open one. Doing so will get you in the habit of capitalizing on the tax savings IRAs provide, and will put you on the path to a bright retirement.

Make sure you consider the benefits and limitations to both options, as well as the eligibility requirements for a Roth.