Five Pillars of Financial Freedom: What does IRA stand for?

 

Hey Freedomites! So I have to say, I am a fantasy football addict. I am just in that mood, hence the picture above. Thank you for indulging me – now let’s get to it.

Be honest did you think IRA was short for individual retirement account? If so you aren’t alone – it actually stands for individual retirement arrangement. Before we jump into IRAs, make sure to check out my prior posts in this series starting with the Intro. We have covered how avoiding bad debt, owning a home, and investing in your retirement plan at work are key to your pursuit of Financial Freedom. Alright, let’s do some IRA lifting and get pumped!

There are two types of IRAs – a Traditional IRA and a Roth IRA. But before we dive into the details, if you do not have an IRA and you want to open an IRA, it is simple. I have always used TD Ameritrade so I am biased. I am certain there are other wonderful online brokers, but I have had a great experience with TD Ameritrade. I will say that the commissions are around $5, which isn’t the cheapest option. However, I think it is worth it to be able to have access to TD Ameritrade’s trading platform, ThinkorSwim, as well as the educational materials on the site. Last, TD Ameritrade has always been much better for me around tax time than some discount brokers I have used. Oh, and that is not an affiliate link – I don’t get paid if you click on it.

So you are ready to open your IRA, now what? Glad you asked – you need to decide whether to open a Traditional or Roth IRA, or both. The Traditional IRA allows you to contribute money and receive a deduction (this is what is referred to as pre-tax money). In a previous post, I talked about the value of a deduction and commented that if you do not itemize your deductions, then the mortgage interest deduction is not actually reducing the taxes you pay. This IRA thing is a totally different animal. The deduction you receive for your contribution to the Traditional IRA is what is known as an “above the line” deduction. That means that the deduction reduces your total income. This means that regardless of whether you itemize your deductions or take the standard deduction you still get the benefit of the deduction for a contribution to your IRA because it reduces your total income.

Here is an quick and dirty tax lesson. Your income tax is calculated as follows:

Add all income to determine your TOTAL INCOME.

Take your total income and subtract off “above the line deductions” to determine your ADJUSTED GROSS INCOME.

Take your AGI and reduce by “below the line deductions” (i.e. standard deduction or itemized deductions – think mortgage interest) to reach your TAXABLE INCOME.

Taxable Income is then used to calculate the actual tax you should pay for the year.

As you can see, we love, love, love above the line deductions because they reduce your adjusted gross income dollar for dollar, which in turn can push you into a lower tax bracket and means you play less income tax.

Alright, so the Traditional IRA results in you receiving an above the line deduction in an amount equal to your contribution.  How much can you contribute you ask? In 2017, you can contribute a maximum of $5,500 to all of your IRAs. This can be split up between a Traditional and a Roth, but you cannot contribute more than $5,500 in total, unless of course you are a young spring chicken with at least 50 years in this League of Life. If that is you, go ahead and put $6,500 in your IRA. Please note that if you are covered by a retirement plan at work and earn more than $62,000 (single) or $99,000 (married), then your contribution may or may not be fully deductible. Check with your tax professional. If you are unsure, you can always contribute to the Roth IRA to be safe.

A Roth IRA does not generate a deduction for you, but when you withdraw the money from your Roth IRA at retirement age (at least 59.5), you do not pay any income tax on the money! Also, because you are not getting a deduction up-front, there is no issue with losing your deduction because your income is too high. However, keep in mind that if your income exceeds $186,000 (married) or $118,000 (single), then you may not be able to contribute the full $5,500 to your Roth IRA. Here is a handy chart to help understand the fundamental difference between the Roth and the Traditional.

Contribution Deductible? Withdrawals Taxed?
Traditional IRA Yes Yes
Roth IRA No No

So why are these accounts so important for building financial wealth? Because the money that you invest in stocks inside these accounts grows completely tax-free (Roth) or tax-deferred (Traditional).

Assume you bought 1 share of Apple stock today for $150.00. News comes out that the iPhone 8 is shattering sales records and tomorrow your 1 share is worth $300.00. That is a pretty amazing investment so you sell it and lock in your $150.00 profit. Unfortunately, since you did not own this stock in your IRA, you will have a short-term capital gain of $150.00. A short-term capital gain is a gain realized on the sale of a capital asset that you held for less than a year. A short-term capital gain is treated just like ordinary income you earn at work. Assuming you have no capital losses and you are in the 25% tax bracket, you would pay $37.50 to Uncle Sam ($150.00 gain * 25%) and be left with $262.50 to invest in the next hot tech company.

On the other hand, had you done the exact same thing in your IRA, you would pay zero, that’s right zero taxes on the $150.00 gain you realized when you sold that share of Apple stock. This leaves you with your full $300.00 to reinvest. Over time, this makes a huge difference.  To illustrate, if you invest $10,000, earn 12% per year, with a 20% turnover rate (ignore this if it confuses you), and are in the 28% tax bracket both on the day you invest the money as well as 35 years later, you will only have $218,130 if you invest in a taxable account. If you invested in a Roth or Traditional IRA (or other tax-deferred growth account like a 401k), you would have a whopping $527,800 – more than double!!! Go here for an academic article illustrating the math behind the above numbers … if you are an insomniac it will do wonders for you.

Big Picture

Each year you should do everything you can to put $5,500 into an IRA. The tax-free/deferred growth is infinitely better than a taxable account, all things being equal. If you need help opening an IRA or with any other financial matter, leave a comment with your email address and I will try to point you in the right direction.

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