Retirement plans - IRA and Roth IRA

We will focus on simple rules of thumb and simple strategies that anyone can use. We will skip many IRS rules and details - you should check with your accountant each year, as tax laws can and do change.

While this page focuses on the retirement plans in the United States, the discussion of their benefits is applicable to almost any country inthe world, since most countries have adopted some sort of retirement program - though the specific tax advantages will differ from country to country.

Both IRA and 401k plans come in two flavors - traditional (IRA, 401K) and Roth (Roth IRA, Roth 401k). Both programs allow your money to grow tax free, but there are 2 significant differences between regular and Roth plans: Traditional IRA and traditional 401k allow participants to contribute PRE-TAX money to the plan, but when the money is taken out at retirement, it is subject to income taxes at the individual's regular tax rate - both the contributions and the earnings.
Roth IRA and Roth 401k allow participants to contribute money only after it has been taxes, but when the money is taken out at retirement, it is tax free - both the contributions and the earnings. Click here to read more about 401k plans.




IRA and Roth IRA strategies

Basic question between traditional and Roth IRA is - do you think your tax rate will be lower when you retire?
If you answer Yes - then traditional IRA is for you.
If you answer No - then you should use Roth IRA.

Robert Kiyosaki is fond of saying, that if you plan to pay at a lower tax rate when you retire, this implies that you are planning to fail - planning to make less in retirement than now. Well... we do not entirely agree. It's OK to plan to have lots of assets and income when retired, but for the time being, we want to take advantage of the available tax breaks - we prefer immediate gratification of tax savings today, instead of 30-40 years from now (and later, we will show you a strategy that gives you the best of both worlds).

So, preferred, strategy 1: fund Traditional IRA every year- currently you can put in $5000 per year ($6000 if you are over 50 years old). In doing so, average person will save about $1500/year in taxes (assuming 30% combined Federal and state tax bracket). So you end up with $5000 in IRA account that will grow tax free until retirement, and you get $1500 tax saving - you could invest this in a regular investment account, or take a nice vacation - thanks to IRS and Uncle Sam.

Strategy 2: If you are covered by a retirement program at work (including 401k and 403b), IRS limits how much you can make and still get a tax deduction for IRA contributions. After you hit this limit, they disallow tax deductions for IRA contributions. So if you make too much to qualify for a traditional IRA (most professionals do), fund a Roth IRA - individuals with income up to $95000/year can fully fund a Roth IRA - $5000 per year, $6000 if you are over 50 years old.

Strategy 3: if you cannot get a tax deduction for your IRA because you make too much money and are covered by employer retirement plan, and you cannot fund Roth IRA because you make too much, you can still contribute to a Traditional IRA with non-tax deductible contributions - you will not get a tax deduction, but the earnings on the money will grow tax free inside the IRA (must file IRS Form 8606)

IMPORTANT: many ignorant people will tell you that you should not contribute to an IRA because you cannot get the money out before age 59 and a half, without paying an additional 10% tax penalty. They are wrong. While we do not recommend draining your IRA, if you really need the money, there is a way to get at it (in installments) without paying the 10% penalty (regular taxes still apply). There is a special IRS code provision, known as Internal Revenue Code (IRC) Section 72(t)(2)(A)(iv). You can't take it all at once, but if you retire early, for example, you could get monthly distributions from your IRA without the penalty, long before you reach the official retirement age.

Do not forget: if your spouse does not work, you can still make contributions to his/her (separate) IRA account.

Education IRA - also known as Coverdell IRA or Coverdell Educational Savings Account - you can contribute $2000 per year (not tax deductible) to an Education IRA for a minor child - money to be spent for education expenses. There are of course limitations - check with your accountant.

Of course, if you REALLy want to, you can read the gory IRA details yourself, in the IRS Publication 590.

So what kind of investments can you put in your IRA? Pretty much unlimited. IRS says you cannot buy collectibles and gold (except American Gold Eagles - the modern ones). Other than that, there are no IRS limits. However, your custodian will impose limits - most IRAs are with banks and brokerage accounts. They are very restrictive as to what you can own in your IRA. If you want something else, look for a truly "self-directed IRA" custodians who will let you invest in what you want, not what they want. BTW: if you want to invest in gold and silver in your IRA - and you have a regular brokerage account - you could buy exchange traded funds (ETFs) that hold gold (stock ticker symbol GLD) and silver (stock ticker symbol SLv).

Now, about that promised "best of both worlds" strategy - click here to see how you can fund both 401K and an IRA.

 

 


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