First, we need to make sure that we're using the same definition of what an IRA is, because when I use that term, a surprisingly large number of people ask me to define what an IRA is.
IRA stands for Individual Retirement Account.
Key words are Individual and Retirement. So it is for you personally. There are no joint IRAs because the very nature is that it's an individual account. You can and should have a beneficiary, but it’s not their account it’s your individual account.
The other part is it’s a retirement account, which means that you put money into it and it's intended for your retirement at some point in the future.
It is not a short-term savings account that you put money in and pull out as needed. You can do that, but there are penalties involved in doing that because that's not what it's designed for.
The Account part is that it’s not the investment itself, it holds the various types of investments and there are a lot of different types of investments that can be held within an IRA.
Some confusion arises when you yourself can set up a personal IRA, but the company you work for might have a retirement plan such as a SEP IRA or a SIMPLE IRA. Those are also IRA accounts but the source of funding comes from different places in each of these types.
Here is a link to my website with a short description of both types. https://www.vwshi.com/resource-center/retirement/retirement-plan-choices-for-small-businesses
You can also setup a SEP IRA or a SIMPLE IRA if you are self-employed.
Let’s set up an initial call to talk about that very soon if you are self-employed or have a side gig so you can start saving for retirement. Use the links at the bottom of this article to do that.
So what’s the difference between an IRA and a Roth IRA? Big difference.
Both are methods to save for retirement and both involve tax choices to make both now and possibly decades from now.
Generally speaking when the term “IRA” is used it stands for a Traditional IRA although its always a good idea to confirm that in a conversation.
A Traditional IRA is a pretax IRA and a Roth IRA is an after tax IRA. Roth is not an acronym for something. It's named after Senator Roth, who proposed the concept of an after-tax IRA.
So what does pretax and after tax mean?
The term pretax can be used in a lot of different ways, but for the most part, it means that you get to put in money into some sort of account or have some sort of use of money before you pay taxes on it.
That’s an important concept because you are using money that might be considered “worth more” because its not what’s left over after taxes have been deducted but money you get to use before taxes are even deducted.
Quite often it also allows you to get a tax deduction in that it lowers your taxable income and because it lowers your income, it lowers the amount of tax that you pay and who doesn’t want to pay less tax?
A Roth IRA on the other hand is after tax. The money that you put into a Roth IRA is after you've paid tax on it. So you have less to use because its money left over after taxes have been deducted
How much tax do you pay, how much tax are you avoiding by using pretax or after-tax money?
That depends on your particular tax rate. You might be in an effective tax rate of 10%, which means your taxable income is assessed tax at 10%. If you are at a 30% tax rate your taxable income is taxed at a 30% rate.
So if you are able to put money into a pretax account generally in that year you report lower taxable income and therefore pay less tax – that year.
How does that actually happen to report lower income?
If it’s a Traditional IRA contribution you report it on Schedule 1 which results in an adjustment downward to taxable income on Page 1 of the Form 1040.
If it’s a pretax 401K this example might be easier to visualize. Look at your most recent Form W2 used on last year’s tax return. Look at Box 1, 3 and 5. Those are three different wages, Gross Wages, Social Security Wages and Medicare Wages. They might all be the same number or each box have a different number depending on your pay situation and benefits that exist at your company.
Box 1 is the line that goes on your income tax return on the Wages line. So let’s say that you contributed $6,000 to your 401K account, then all else being equal, Box 1 Gross Wages should be $6,000 less than Box 3 and its Box 1 that shows up on your tax return as you start working towards taxable income and the tax you owe calculation. So you are reporting $6,000 less income than you earned.
Similar concept but different line items for a contribution to a Traditional IRA.
But when you put money into a Roth IRA, it's considered after tax, meaning it's money that you've already paid tax on so you get no tax deduction for it.
A logical question then is why would you choose to pass up on a tax deduction by putting money in an after tax (Roth) account?
That is a huge tax planning discussion and opportunity and a chance to possibly save tens of thousands of dollars in lifetime taxes and why in my opinion you should only work with a retirement planner who will also give you complete tax advice.
Remember - Pay Less Tax, Grow Your Wealth. Pay less tax, redirect the savings to your retirement accounts.
Putting money into a pretax IRA or retirement account now gets you a tax deduction now - yay - that sounds like a great deal doesn’t it?
But wait there’s more – what if you are in a relatively low tax bracket? Perhaps you are still early in your career and not yet at your higher earnings potential (and higher tax brackets).
What if for some reason life events caused your income this year to be lower and your lower income pulled you down into a lower tax bracket?
Remember that when we are talking retirement money we are talking money used for decades into the future and future tax rate assumptions are the crucial decision to make.
Even if you are in your 50s and you think you’ll start accessing your retirement money in your 60s, that’s only 10 years away and you think rates might not change much and you might be right.
But that same pot of money you may start accessing only 10 years from now might very well be the same money you are accessing 30 years from now when you are in your 80s.
Money that you were able to put aside on a pretax basis is not tax free, its tax deferred. So you got a good tax break when you contributed to the account, but years, decades from now as you access that account in your retirement years it will be taxable income.
You will be taxed on it at whatever tax rates exist in the future. Will they be higher or lower? None of us can predict the future but some things to consider.
The current tax rate structure we are in right now is among the lowest in decades. That’s not my guess, I’ve seen it presented many times by many different people over the last few years.
So if we are in a relatively low tax rate now, then it’s not a stretch to think that tax rates are likely to go up over the long term or decades from now and since we’re talking retirement money the timeline to think about is decades.
If you contribute to a Roth IRA (or Roth 401K) that’s after-tax money and under current tax rules, years from now, decades from now when you draw on that money, its tax free. You were taxed on it before you contributed to the retirement account so you have already paid the tax years earlier.
So – which account is better? Depends - but you probably already knew I was going to say that.
If you are in your later career earning years and making high income and consistently in the higher tax brackets perhaps in your case it might make sense to take the pretax deductions now with the reasoning that you might well drop into a lower tax bracket when you retire,
But if you are in your 20s, 30s, 40s or even 50s and especially in a lower tax bracket, perhaps you should consider forgoing the tax deduction now to have tax free income decades from now.
I mention tax bracket and effective tax rates a lot above. If you don’t know what your rates and brackets are ask your financial advisor and see if they will help or they brush you off and tell you they are not allowed to give tax help. (Calculating a rate is not tax advice)
If they won’t help then it’s time to set up that introductory call to start getting financial and tax advice at the same place using the contact me links below.
Here is another link with some current contribution thresholds.
The information in this and other articles is intended to be educational in nature only. Not tax, legal or investment guidance for you specifically. Each person’s situation is unique and you must seek appropriate professional guidance that can address your unique situation.