I think by now every American knows they have to stock something away for their old age. Whether us millennials want to call it a retirement, or just a “f*ck you, working!” lifestyle is totally debatable, but we still need to save something. When most people think of a retirement account, an employer set-up 401(k) is usually the go-to.
What if your work doesn’t offer a 401(k)? Almost half of private-sector workers don’t have the option to save into one. If you’re one of those people, then your next best option likely is an IRA.
So, WTF is an IRA?
IRA stands for “Individual Retirement Account”. As the name suggests, it’s a type of account meant for one person to save for their retirement. Yes, I know, that doesn’t help explain much. The most important thing to know about IRA accounts is that they are tax advantaged, meaning the laws allow avoiding taxes (tax-exempt), kicking the tax can down the road (tax-deferred), or sometimes both (freebies!!).
Nobody likes paying taxes. Just ask the colonial Americans. They threw a bunch of tea in a harbor because of taxes. And they really liked tea.
Congress understands that people sometimes need a little nudge to do something, so they’ve granted tax-advantaged status to certain accounts and investments in order to encourage people to invest in them. This is the case for retirement accounts.
Putting money in a designated retirement account means you’re taking care of yourself in the future. That’s definitely something Congress wants. And once you’ve got money in a retirement account, Congress wants you to keep it there. They’ve written some penalties into law so you do that.
With some exceptions, money put into retirement accounts has to stay there until age 59.5 or risk a penalty. Not only will early withdrawals be taxed as income, the IRS will take an additional 10% of the withdrawal.
There are different types of IRAs for different situations. Let’s break ’em down:
The Traditional IRA
The OG of IRAs has only been around since 1974. A traditional IRA allows any worker earning less than a specified amount of income ($83k for singles, $136k for married-filing-jointly in 2023) to subtract the amount of money they put into the IRA from their income for taxes.
Even if you earn more than the salary limits, you can put money into an IRA. It just won’t be tax deductible.
Deductible or not, once money is in the account, it can be invested and grow tax free as long as it stays in an IRA. This is a HUGE benefit. So, of course, people have abused it. Because we can’t have nice things. Congress and the IRS have put rules around the traditional IRA to make sure it helps retirees and doesn’t become a tax-free vehicle for wealthy people to pass on cash.
The first rule limits how much money you can add to IRA accounts in a year. No one can put more than $6,500 or their taxable income, whichever is less, into all their IRAs. No squirreling away unlimited nuts.
The second rule forces retirees to take some of their money out. Once an account owner blows out the candles on their 73rd birthday cake, they need to start withdrawing at least a certain amount of money each year. The amount will be determined by their account value on December 31 of the year before (so 2023’s amount was set at the end of December 31, 2022) multiplied by a life-expectancy factor set by the IRS. This is because the IRS wants their tax money. Money pulled out of an IRA is considered income and is — you guessed it — taxed as income. This isn’t a problem while you’re young and kickin’ it, but it can become a problem with age.
The Roth IRA
Roth IRAs are the baby of the retirement account world. Senator William Roth sponsored the bill making Roth saving legal in 1997. What a way to make sure you name is remembered forever.
Roth’s are generally best when Current You is in a lower bracket than Future You. The name of the Roth-vs-traditional game is to pay as little as legally possible to Uncle Sam.
These accounts are similar to traditional IRAs in that investments inside grow without taxes, but that’s about where the family resemblance ends. While IRAs give a tax deduction when you put money in, Roth cash doesn’t give you any kind of a tax break going in. But because they’ve been taxed going in (as part of your income), all the money comes out tax free. After it’s grown, tax free. This is an opportunity to potentially generate a big pile of after-tax money for retirement.
There are ripple effects beyond just a smaller retirement tax bill, too. How much a retiree pays in Medicare premiums and how much they are taxed on Social Security is determined by their Modified Adjusted Gross Income (MAGI). Traditional IRA distributions are included in MAGI; Roth payouts are not.
Because of these sweet perks, there are limits to how much you can earn and still put money into a Roth. But — like wayyy too many tax laws — there are ways around these limits. I recommend talking to a financial advisor to learn if this is the case for you.
Roth accounts carry the same caps on how much money can be added to them each year as IRAs. Again, the 2023 limit is $6,500 across both traditional AND Roth accounts. You can’t max out one and the other in the same year.
One last benefit Roth IRAs have over their traditional siblings is the ability to withdraw contributions from the account at any time after the account turns 5 years old, without tax penalty. This should only be considered as a last resort, but it is a nice perk in tight situations.
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