IRA stands for Individual Retirement Arrangement (not "Account" as most people believe). This is a type of account that allows you to save money for your retirement. The main advantage of an IRA is that it allows you to save money on taxes. In an effort to encourage people to save for their retirement, the Government has provided certain tax advantages for saving money in an IRA. There are three main flavors of IRA's:
1. Traditional IRA
2. Non-deductible Traditional IRA
3. Roth IRA
All three allow you save money for retirement, but each one is treated differently for tax purposes. For more information about IRA, you can refer to IRS Publication 590 - the definitive source for information on IRA's
A Traditional IRA allows you to contribute up to a certain amount towards your retirement account. Generally speaking, you can contribute up to $5,000 in 2010. However, if you are over 50, you can contribute up to $6,000. The value of your contribution can be taken as a tax deduction on your 2010 taxes, which means that you don't pay taxes on the amount you contributed. This allows you to invest the full amount of your investment towards retirement without having to set aside money to pay for taxes. In addition, if you earn interest, dividends, or capital gains on the money in your IRA, you don't have to pay taxes on those earnings either.
The catch to this tax benefit is that when you withdraw money from your IRA in retirement, you have to pay taxes on your withdrawal. However, if your tax bracket is lower in retirement than it was when you contributed, this isn't such a bad deal. If that is the case, the money that you withdraw is taxed at a lower rate.
There are a couple of other catches. If your employer has a retirement plan, there are limits to what you can deduct based upon your income level. If you are single, made more than $66,000 in 2010, and covered by a retirement plan, you cannot deduct your Traditional IRA contribution. Bummer. How do you know if you are covered by what the IRS considers to be a retirement plan? Check your W-2 form.
Non-deductible Traditional IRA
As the name suggests, this is a Traditional IRA where you cannot deduct your contributions. If your employee has a retirement plan and you make more than the IRS limits, then you would fall into this category. Because you still have to pay taxes on your contributions, this flavor of IRA works a little differently. The earnings on your contributions still grow tax free, just like in a Traditional IRA. However, when you withdraw your money, you only pay taxes on the earnings; you don't pay taxes on your contributions.
Let's say you contributed $5,000 to your non-deductible IRA, and let it grow for 20 years. After 20 years, your account now has $9,000. Now let's assume that you withdraw all of that money for your retirement. Only $4,000 counts towards your taxes - the $4,000 that represents your gains on investment. The $5,000 that represents your original contribution isn't taxed.
A Roth IRA turns the Traditional IRA on its head. Your contributions are not tax deductible, meaning that you pay taxes on them up front. However, when you withdraw your money in retirement, you don't pay any taxes on the money you take out. Basically, you are paying taxes up front.
If you anticipate being in a lower tax bracket at the time your are contributing compared to during retirement, then a Roth IRA generally beats a Traditional IRA. However, if your tax rate is higher now, generally your better off in a Traditional IRA (assuming it is deductible).
The Roth IRA has its own little twist. If your income is greater than a certain threshold, you cannot contribute to a Roth IRA. Of course, if your income is high, your tax rate is high so you probably shouldn't be in a Roth IRA anyway!
Here is a quick summary of the three IRA's discussed:
|IRA Type||Are Contributions Taxes?||Are Earnings Taxed?||Are Withdrawals Taxable?||Other Notes|
|Traditional, Deductible||No||No||Yes||Income limits if in a retirement plan|
|Traditional, Non-deductible||Yes||No||Only Earnings|
There are other nuances related to minimum withdrawals, early withdrawal penalties, and the like, but this covers the basics.
One thing that stands out is the fact that the Traditional, Non-deductible IRA is a bad deal compared to a Roth IRA. In both cases, you pay taxes on contributions, but not earnings. However, when you withdraw your money, a Roth IRA lets you off the hook without any taxes, while you pay taxes on earnings when you withdraw from a Traditional, Non-deductible IRA. Why would you want to contribute to a Traditional IRA when you cannot deduct your contributions?
There is one situation where this makes sense. If your income is over the Roth IRA contribution limit, and you are covered by a retirement plan, then the Traditional, Non-deductible IRA is the only game in town. The good thing is that there is a "backdoor" way to open a Roth IRA. While you may not be able to contribute to a Roth IRA directly, you can convert a Traditional IRA to a Roth IRA without any income limit. This strategy goes something like this:
1. Contribute to a Traditional, Non-deductible IRA. Because there is no income limit, you can contribute up to the limit regardless of your income.
2. Convert your Traditional IRA to a Roth IRA. At a later point in time, you perform the Roth IRA conversion. IRS Publication 590 says the following:
"You must include in your gross income distributions from a traditional IRA that you would have had to include in income if you had not converted them into a Roth IRA"
If you had withdrawn this money from your IRA and not converted it, you would only have to pay taxes on the earnings. You wouldn't have to pay taxes on the contributions. If you were to perform the conversion immediately after contributing to your Traditional, Non-deductible IRA, you would have no earnings. Therefore you would have no taxes. In essence, you have created a no-income-limit Roth IRA for yourself. Now when you withdraw money from your Roth IRA in retirement, you won't have to pay taxes on your contributions or your earnings. Sweet deal!
[Important Note: As always, talk to your tax advisor to see if this strategy is right for you!]