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Basic Finance Lesson 9: Classic IRAs vs Roth IRAs

The following is a very basic post on classic IRAs vs Roth IRAs. Retirement accounts can get a lot more exciting than this once you have money to put in them and, especially if you own your own business. To give you an example, while IRAs limit you to 5K per year in contributions, SEPPS accounts allow business owners to put away 5oK per year instead (more if you are married and each of you have a business). In addition, there are some very interesting non-traditional methods of investing retirement funds that I really like but won’t get into during this basic finance bootcamp. Suffice it to say, if you are not making the big bucks yet, you really ought to know about the Roth IRA option which I think is really a steal. Learn this stuff now and follow me later for more exotic stuff in the near future if you have the cash! So…back to the task at hand.

There are a number of tax-advantaged ways to save for retirement.  The eligibility requirements vary, and not all the plans are available to everyone.  Two options that are available to most workers are the Classic and Roth IRAs.

An IRA is not, itself, an investment; it is simply an account in which the account owner can invest in a number of different types of assets, ranging from bank certificates of deposits to mutual funds, to individual stocks and bonds, to real estate, and earn income that is tax-deferred.  Under some circumstances, the amount invested in a Classic IRA account is tax deductible.

To appreciate the advantages of investing via an IRA, even when the investment amount is not tax deductible, consider the following simplified example:

Assume that you open a Roth IRA with a single lump-sum contribution of $5,000 and use the money in the account to purchase shares of a mutual fund that returns 8% a year.  Contributions to a Roth IRA are not tax deductible, but although you cannot deduct this $5,000 when calculating your taxes this year, the money this investment earns will grow tax-free.  Had you invested the $5,000 in a non-IRA account paying an annual return of 8% a year, the amount you would have accumulated at retirement will be far less, as illustrated in the table below:

 

Number of years later Amount in Roth IRA account Amount in non-IRA account, assuming a 28% marginal tax rate
10 $10,795 $8,755
15 $15,860 $11,580
25 $34,240 $20,275
30 $50,315 $26,830
35 $73,925 $35,500

 

The amount in your Roth IRA account is more than twice the amount in your non-IRA account at the end of 35 years because you didn’t have to pay taxes on the earnings each year. After paying taxes at a rate of 28%, the money deposited in your non-IRA account grew at only 5.76% a year. And once you reach the age of 59 ½, any withdrawals you make are tax-free if your Roth IRA account has been in existence for 5 years or more.

You can establish an IRA account easily through either your financial institution (e.g., your bank) or your brokerage firm.  Just fill out the requisite paperwork and fund it.  You can elect to have an investment professional make the IRA investment decisions for you, or you can establish it as a self-directed IRA, which enables you to select the specific investments and generally gives you a wider range of investment choices.

Unfortunately, the amount you can invest in either a Classic IRA or a Roth IRA account is limited, and not everyone is eligible to open an IRA account.  You must have earned income.  This doesn’t include income from investments—only employer compensation. You must also meet income restrictions in order to open a Roth IRA account.

For 2012, the maximum total contribution that can be made to your combined IRA accounts is $5,000 ($6,000 for those 50 years of age or older) or 100% of your total employment compensation, whichever is less.  These contributions can be made any time on or before April 15, 2013 to be included in your 2012 income tax filing.  In 2013, the contribution limit is scheduled to increase to $5,500 (or $6,500 for those 50 years of age or older).

Anyone under the age of 70 ½ can contribute to a Classic IRA, and there is no age restriction on the Roth IRA as long as the individual has earned income, as defined earlier.  Furthermore, although there are income restrictions that must be met in order to invest in a Roth IRA, anyone with earned income can invest in a Classic IRA, regardless of whether or not he is also investing in an employer-sponsored retirement account, such as a 401k plan.

If you aren’t invested in an employer-sponsored plan, you can contribute the maximum allowed to a Classic IRA, and your entire contribution will be tax deductible.  If you (and/or your spouse, if married) are enrolled in an employer-sponsored plan, then the amount of your contribution may only be partially deductible–or not tax-deductible at all, depending on your income level.   The tax-deductible contribution limits change from year-to-year.  Regardless, your earnings will grow tax-deferred in a Classic IRA, and you will pay taxes on them upon withdrawal, as well as on any tax-deductible contributions you have made.

The qualifications for a Roth IRA account are a bit more complicated.  Single individuals with taxable income less than $110,000 in 2012 can contribute the maximum amount allowed, as specified earlier, in a Roth IRA; those earning $110,000 to $125,000 are able to invest only part of the maximum allowed in a Roth IRA, and those earning over $125,000 are ineligible to contribute to a Roth IRA account. In 2013, the income limitation for maximum contribution is increased to “less than $112,000,” and partial contributions are allowed for income between $112,000 and $127,000, inclusive.

Individuals filing in the “married filing jointly” category can make the maximum contribution to a Roth IRA if the joint income reported is less than or equal $173,000 in 2012.  They are ineligible to contribute anything to a Roth IRA if the joint income reported exceeds $183,000, but are able to contribute something to a Roth IRA if the income is over $173,000, but less than or equal to $183,000.  In 2013, the maximum income level allowed for a maximum contribution is $178,000, and contributions are not allowed at all for married-filing-jointly individuals whose reported taxable income exceeds $188,000.

Roth IRAs provide a few benefits that aren’t available with the Classic IRA and other tax-advantaged retirement accounts:

  • You can withdraw contributions made to a Roth IRA at any time, regardless of age, without penalty or additional taxes.  (Remember, you already paid taxes on the amount you contributed to your Roth IRA.)  All withdrawals before age 59 ½ from a Classic IRA are subject to a 10% early withdrawal penalty unless one of the few specific exceptions apply (e.g., disability, higher-education expenses, qualified first-time home purchase).
  •  Earnings from a Roth IRA can be withdrawn tax-free as long as the account has been in existence for at least 5 years and the account holder is at least 59 ½ years old.  Earnings withdrawn from a Classic IRA are taxed regardless.
  • There are no age withdrawal requirements with a Roth IRA, whereas a Classic IRA mandates minimum withdrawals beginning at age 70 ½.  This makes the Roth IRA a better instrument for estate planning since the accumulation in a Roth IRA account can remain in the account and continue to grow tax-free during the lifetime of the original account holder, who can bequeath the account to his or her heirs.

 

So, that’s classic IRAs vs Roth IRAs in a nutshell. Questions? Let me know below. Otherwise, remember to spread this information to your colleagues, friends or classmates. Everyone needs to know this stuff. And of course, do not forget to sign up for the newsletter which is going to provide you with additional content and opportunities in the near future.