Wednesday, March 23, 2016

What in God's Name is an IRA?



I knew than an IRA was a money-related thing when I was a kid, probably from seeing a banner in a bank window, but I thought it was pronounced "Ira," like the public radio host's name. I understood 401ks for years before I had the fortitude to plunge in and understand what an IRA is, but it turns out they're not so different!

Below, I answer my imaginary twenty-year-old self's questions about IRAs, including explaining what they are, revealing my favorite brokerage, and answering the age-old Roth vs. traditional question with a resounding "meh."


Okay, so what's an IRA, then?

IRA is an acronym and it stands for Individual Retirement Account. Like a 401(k)*, this is a tax-advantaged account designed to help you save for retirement. You can put money in and invest it, and there are penalties for taking it out before you hit retirement age.

* When I say "401(k)" in this post, assume I mean "any employer-sponsored retirement plan," including a 403(b) or 457. For more on these plans, including a brief intro to investing, see What the *** Is a 401(k): A Q&A With My Younger Self.

What's the difference between an IRA and a 401(k)?

The main difference is that it's not associated with your workplace. So you have complete control over it, including deciding what bank or brokerage to use, and how to invest the money. You are not limited by what your employer chooses, and you don't have to move it if you change jobs.

How much money can I put in each year?

Tax code limits how much money you can contribute to your IRA each year. As of this writing, it's a maximum of $5,500 for the year 2016. (If you are over the age of 55, you can put in a bonus $1,000, giving you a maximum of $6,500.)

Another limitation is that you can't put more money into your IRA than you earned in the year. For most working adults, that probably won't be a problem--you probably earn more than $5,500 a year--but financially savvy kids and students sometimes run into this issue. Children can open IRAs, but only if they have earned income which they're reporting to the IRS. So if you earned $700 this year on your paper route, you can invest up to $700 in an IRA.

Is that on top of the money I can put into my 401(k)?

Yup. The maximum for a 401(k) is $18,000 for 2016, so this year, if you max out both accounts, you could theoretically put away $23,500 between them. Of course, this assumes that you have that amount available to invest for retirement and you don't need it for, like, rent! But don't worry if you don't max out your accounts, even though everybody on /r/personalfinance seems to. Any little bit counts. There's no minimum limit to contribute. (Your brokerage might have a minimum to start actually investing, but you can always let your money sit uninvested in your IRA for awhile.)

If I have to pick (and I do), should I invest in my 401(k) or an IRA?

First off, if your employer offers an employer match on any portion of your 401(k) contributions, you should definitely contribute enough to claim the full the match.

After that, if you still have money left over to invest in retirement, I would probably go with your IRA. The reason is that you have more control over it; you can pick any brokerage you want, and any funds you want. With 401(k)s I often find myself picking less-than-ideal funds, like an S&P 500 fund when I'd rather have a Total U.S. Market fund, or a fund with a higher expense ratio than I can get at Vanguard. (I'm not trying to be a shill, just saying, I love Vanguard. I have no relationship with them other than being a happy customer.)

If your workplace offers a really fantastic 401(k), like if they use Vanguard as their brokerage and you can get inexpensive index funds, or you just want to use their Target Retirement fund, then you might just want to throw as much money as you can at that, and forget about IRAs (unless and until you max out your 401(k) completely).

Otherwise, the order of operations I'd suggest is:
  1. Contribute enough to 401(k) to get full employer match
  2. Contribute to IRA until you max it out (or run out of retirement-budgeted money)
  3. Return to 401(k) and contribute until you max it out (or run out of retirement-budgeted money)
Still have money for retirement? Welp, you've run out of tax-advantaged plans, time to invest in a regular old taxable brokerage account.

I'm lost… Remind me how to pick funds for investing?

See my 401(k) post. The investing stuff is the same.

Let's get back to the tax-advantaged stuff. How does that work in an IRA? Is it the same as with a 401(k)?

Okay. This depends on your account type. There are two types of IRAs, Traditional and Roth.

YOU'RE LOSING ME

Bear with me! It's not that bad.

Fine, I'll bite… WHAT ARE THE DIFFERENCES BETWEEN A TRADITIONAL AND ROTH IRA??

A traditional IRA works like a 401(k). You don't have to pay income tax on the money you put in--you have to pay it when you take the money out, after retirement. A Roth IRA is the opposite. You pay income tax on it now, the way you would with any money you earn. But you don't have to pay tax on it when you take it out after retirement.

So which is better, traditional or Roth?

They both have their advantages. Honestly? It doesn't really matter. They're both good. Just save, that's the important thing. Save and invest and you'll be in good shape for retirement, no matter which vehicle you use.

No, really, which is better?!

Okay. If you're really interested, I'll lay out the arguments for each one, as I understand them.

Traditional (no tax now, tax later): The reason this is a good deal is that most retirees have a lower tax bracket than working adults, so by the time you pay tax on the money you withdraw, you'll theoretically be paying less than you would pay on it at the height of your career (unless tax rates rise overall). Also, if you don't have to pay taxes now, that should free up more money for you, so you can contribute more.

Roth (tax now, no tax later): The reason this is a good deal is that the growth is tax-free. You'll (hopefully) have more dollars in your account at retirement than just the dollars you put in: you'll also have any dividends, interest, and stock market gains. I mean, invested money is supposed to grow, that's the whole point, right? Say you put in $1,000 and it grows to $5,000 in 20 years (approximately 8% rate of growth). You already paid tax on the $1,000 and you're taking out $5,000, so that's $4,000 you never have to pay taxes on.

Another advantage of the Roth is that, since you've already paid tax on it, you can take it out without penalty before retirement age if you need to (only your contributions, though, not the gains.) Of course, you should only do this in a worst-case scenario, since it's your retirement money, and you're stuck with a hard and fast contribution limit.

For the love of God, just tell me already: which. Is. BETTER?

People argue about this on the Internet all over the place. The conventional wisdom is that Roth is better for people who are younger (so their money has more time to grow), or in a lower tax bracket. People who are middle-aged or nearing retirement age and/or in a higher tax bracket (say, over 25%) might benefit more from an immediate tax advantage.

Personally, my feeling is that, if you can go Roth, that's almost always the better choice in the real world.

Say you're in the 25% tax bracket and all of this money you're looking to invest would be taxed at 25%, and you are in the same tax bracket at retirement. This is the situation in which the two scenarios are the most similar. If you invest $1,000 in a traditional IRA, and it grows to $5,000 at 8% over 20 years, you end up paying $1,250 on the $5,000 when you take it out, netting $3,750. Now, if you instead invested in a Roth, you'd take out the tax up front--initially investing only $750 instead of $1,000--and assuming the same time frame and rate of return, that amount would grow to about $3,750. So, it's a wash, right?

But the truth is that is not the calculation that human beings make, $1000 in Traditional vs. $750 in a Roth. People generally decide on the amount they want to invest, then decide which account to put it in. And people who are making enough to be in a high tax bracket are more likely to have enough to max it out, so they're really choosing between putting $5,500 in Traditional or $5,500 in Roth. In that comparison, Roth will always come out ahead because you are essentially putting more money in the Roth IRA--a sort of hidden bonus in the form of the money you have already paid in income tax. It just doesn't seem that way psychologically.

The problem with the tax advantage associated with a Traditional IRA is that it isn't necessarily immediate, like a 401(k). Your IRA isn't associated with your workplace, so they don't know anything about it--they won't adjust your paycheck automatically to lower your tax based on your contributions, like they do for your 401(k). You don't get the money "back" until it's realized in the form of a lower tax bill or higher refund at tax time. As long as I'm waiting to realize the advantage, I might as well go Roth and wait longer but see a bigger advantage (maybe).

Plus, the thing where I can take it out again gives me peace of mind. It's like a backup, last-resort emergency fund.

tbh I kinda skimmed that whole explanation.

I know you did.

Honestly, does it really matter?

Nah. Not really. As you can see, you have to kind of dig into the guts of the way they work in order to compare them, and either way it's better than investing in a tin can under your mattress. Don't get hung up on this choice and let it prevent you from investing for retirement. Just pick one. If you want me to decide for you without knowing your situation, well, I'll just tell you to err on the side of Roth, if you're eligible.

"If you're eligible"?

The restrictions for contributing to a Roth IRA are tighter than for a traditional IRA. There are income limits. These change each tax year. Right now, for 2016, you can contribute to a Roth IRA only if you make less than $116,000 a year (single) or $183,000 a year (married filing jointly). There's no income limit for a traditional IRA.

The reason this is so far down the page is that I have never actually met anyone who, that I knew of, made too much money to contribute to an IRA. It sure hasn't been a problem for me yet. Maybe someday.

Out of curiosity, is there such a thing as a Roth 401(k)?

There is! It's rare, though. Many workplaces don't offer a Roth 401(k). The differences between Roth and Traditional are the same in a 401(k) as in an IRA: tax now or later.

I used to work for a place that offered one, but, despite my own advice to go Roth if you can, I didn't take advantage of it. The thing is that with a 401(k), the psychological factors I mentioned didn't apply, since I can't contribute the maximum either way, and I was immediately seeing the result of the tax advantage of the traditional contributions in the form of a lower tax contribution on my paycheck. I actually was deciding how much to contribute based on how much I had available after taxes, instead of deciding on an amount ahead of time regardless of taxes. So, in that case, I feel like the decision was more of a genuine wash. Traditional made me feel better because it enabled me to contribute more dollars.

I make a lot of my financial decisions based on feelings.

I'm not sure if I should listen to you anymore.

I'm not either. But I've run out of things to say about IRAs. Go forth, my child, and invest!

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