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What's an IRA? Do I Need One?

March 15, 2022
Originally published April 2020
Updated March 2022

Around this time of year, we get at least one or two incoming phone calls from people wishing to set up and fund IRA accounts right before the tax filing deadline, because their CPA told them they needed one for tax reasons.

In the spirit of the season (and with the hope that you won't wait until 24 hours before the deadline to act), I'm going to outline the whats, whys, and hows of IRAs.

For the TLDR version, check out the video below. For all the details, read on.

What is it?

IRA stands for Individual Retirement Arrangement – you thought the A was for Account didn't you?!

An IRA is a retirement savings account that is associated only with an individual, as opposed to with your employer (like in a 401(k) or similar).

An IRA allows an individual to save for retirement by depositing money up to a specified limit each year.1

Once that money is deposited into the IRA, it can be held in cash (not the best idea) or used to invest in a variety of securities like individual stocks, individual bonds, mutual funds, or exchange traded funds. As with any element of the U.S. tax code, there are some rules and some nuances.

Let's dive in by discussing the two primary types of IRAs you'll find in the wild: Traditional and Roth.

Traditional IRAs

Most anyone with earned income can contribute to this type of IRA; in 2022, the limit is up to $6,000, plus an additional $1,000 if you are age 50 or over. Contributions are made using money that you've already paid income tax on. Once the money is in the account, any dividend income, interest income, or capital gains that would otherwise be taxable are not taxed until you begin taking money out of the account in retirement.

If your income is below a certain threshold, your Traditional IRA contribution may be tax deductible.2

Roth IRAs

Only certain people with earned income can contribute directly to a Roth IRA based on their income and filing status. For example: if you are married and filing a joint return, you can make a full $6,000 contribution only if your adjusted gross income is less than $204,000 in the year of contribution. (Check out all the limits and phase-outs here.) As with Traditional IRAs, contributions are made with dollars that have already been taxed. Roth IRA contributions are never tax deductible.

So why bother? As with Traditional IRAs, any dividend income, interest income, or capital gains on investments in the account that would otherwise be taxable are not taxed – ever. Even when you take money out of your Roth IRA in retirement, none of it is taxed.

Read: How Much Should I Be Saving? And Where Should I Put It?

Why would I want an IRA?

The key benefits of an IRA are the tax goodies.

Sometimes you get tax goodies today (tax-deductible Traditional IRA contributions), tax goodies over time (tax deferral on investments gains in a Traditional IRA), or tax goodies tomorrow (tax-free investment gains in a Roth IRA).

This may feel abstract, so let's do some simple math.

Deductible contributions

Let's say you are married and file a joint return. Your modified adjusted gross income is less than $109,000, and both you and your spouse make $6,000 Traditional IRA contributions. You can now deduct $12,000 from your adjusted gross income. Adjusted gross income drives your tax bill, so lowering this number will result in a lower tax bill. That's up to $2,880 less in taxes you'll pay for the year. Put another way, that's up to $2,880 that will stay in your pocket.

But what if you earn too much to deduct?

Tax deferral

Regardless of your ability to deduct your contributions, you'll still enjoy tax deferral on your IRA savings. For example, say you choose to invest your IRA money in shares of the well-diversified XYZ fund - during the year, XYZ fund zooms up 30%. Your $6,000 is now $7,800, and you want to take your profit and invest it in another security. If you did this in a non-IRA account, your $7,800 would become only $7,530 because you'd owe capital gains taxes. In an IRA, there are no capital gains taxes due that year. This means two things: 1) your tax bill doesn't go up that year, and 2) more of your money stays invested - which means more of your money is compounding.3

Over time, keeping those dollars working (instead of sending some of them to Uncle Sam) means you'll have a bigger pot of money to blow in retirement on whatever it is that makes you happy. Tax deferral on your investments is like fertilizer for a garden – it helps things grow a little faster.

Read: How Do Taxes Work

What's the catch?

I'm glad you asked. IRAs come with some caveats that you need to be aware of before you make that first deposit.

  • Caveat #1: In general, you can't take money out of an IRA until you attain age 59½. If you take money out early (and you don't qualify for an exception), you'll be subject to a 10% penalty tax in addition to any income tax due.
  • Caveat #2: You need to make some choices about what to own. Putting cash in an IRA and letting it just sit there uninvested somewhat defeats the purpose of the account.
  • Caveat #3: The burden of record keeping is on you. If you make nondeductible contributions to a Traditional IRA, you need to track those. Why? Because if you've already paid taxes on those dollars (and got no deduction the year you contributed), you don't want to pay taxes again when you withdraw the funds from your Traditional IRA. The IRS won't keep track of this for you.
  • Caveat #4: Traditional IRAs are subject to Required Minimum Distributions (RMD) once the account owner attains age 72. At some point the tax deferral party will end, and Uncle Sam will demand his cut. Your annual RMD is calculated using this formula:

IRA Account Balance on December 31 of Prior Year = RMD

Uniform Lifetime Table Factor4

If you fail to take your annual RMD, you'll be assessed a 50% penalty tax on the RMD amount.

Do I need one?

This is less a question of need and more one of want.

I believe that most retirement savers need an IRA, and having one is integral to a sound financial plan.

It's a powerful wealth-building tool.

If you are a younger investor (I'm looking at you Millennials and Gen Z), opening an IRA now and funding it every year until you turn 72 or retire can set you up for exponential growth over time (see the compounding calculator in footnote 3).

Ready to make an IRA part of your Financial Plan?

Book Your Free One-Hour Consultation

1 I want to take a moment to emphasize that if you don't contribute to an IRA in a given year, you can't ever go back and make up contribution in future. Once the annual opportunity is gone, it's gone forever.
2 Consult your tax advisor to see if you qualify to deduct your Traditional IRA contributions.
3 You can learn all about compounding here – it's a pretty big deal.
4 View the Uniform Lifetime Table here.