Does an IRA offer anything better than what you get with Index funds?
It’s not an either-or thing.
You can open an IRA account at a brokerage firm or a mutual fund company and invest the balance of your IRA in an index fund if you like.
But does an IRA offer anything? Wouldn’t the only ‘benefit’ be that I’m not allowed to withdraw the money until 59?
The reason people choose IRAs over taxable investment accounts is that IRAs provide substantial tax benefits. There are several different types of IRAs, each with different benefits. In a traditional IRA, you do not have to pay ordinary income tax on the money you put in. You pay income tax only when you withdraw the money in retirement. If, like many people, your tax rate is lower in retirement, you save considerably on taxes. In a Roth IRA, you put the money in after taxes, but then you never have to pay taxes on it again, so any investment gains you make are completely tax free, and the money you take out in retirement is not counted toward your income for tax purposes. The rules can be more complicated, but these are the basics, and why it makes sense to use an IRA for your investments if it’s available to you.
You are allowed to withdraw money from an IRA before age 59.5, but there may be a financial penalty for doing so. And if you decide that an index fund is not the right investment for you, you can change the investment in your IRA account at any age, subject to whatever transaction fees the brokerage firm or mutual fund may impose.
There are two types of IRA: Traditional IRA and Roth IRA. (Ok, there are a couple of other more obscure ones mostly for self-employed people.)
With the Traditional IRA, you may be able to claim a deduction for your contributions in the year you contribute. You don’t pay any taxes on dividends or when you sell shares of your investments. But you will pay taxes on any distributions (“withdrawals”) you take at ordinary income rates. Essentially, you take the gamble that you will be in a lower tax bracket when you withdraw than when you deposit. Since you pay at ordinary income rates, there is an argument to be made that you might have been better off making the same investments outside the IRA where you might have only paid capital gains rates.
With the Roth IRA, you get no deduction at the time you make a contribution, but if you wait long enough, you will never have to pay any taxes on any distributions you take out in retirement. This has a double benefit since your distributions won’t count as income for purposes of Medicare premiums and calculating taxes on Social Security benefits. And the Roth IRA allows you to take out an amount up to the value of your contributions at ANY time without tax or penalty.
So, you do get tax advantages by using an IRA. If you are just interested in investing in mutual funds, you will have most of the same options and the same before-tax returns in either case.
Most mutual funds (like index funds) return dividends throughout the year. If you just open a regular mutual fund, then you will have to pay taxes on those dividends each year. Even if you have the dividends reinvested, you still have to pay taxes. And each time you sell shares from a fund, you will have to pay taxes on any profits you made from when you originally bought the shares.
If instead you open an IRA and use that to buy the mutual fund, then the dividends are not taxable and you can buy and sell funds without having to pay taxes. The IRA is a shelter from all the taxes until you withdraw the money.
As others have noted, the tax-free growth in an IRA is the biggest difference (and great advantage) but it should be noted that there is a limit to the annual contributions to an IRA.
The usual approach to retirement savings is to contribute the max to :
Employer 401k or IRA then Roth IRA
Then to a regular savings investment account.
I recommend running the numbers with a few different assumed tax rates and rates of return, both with and without the tax benefits. That will show you the advantage of a tax-advantaged account.
Keep in mind that traditional and Roth IRAs work differently, and they have limits on what you can put in and take out. Their respective wikipedia pages explain it pretty well.
I have my IRA account invested in a variety of index funds.
If possible, make the maximum contributions to your IRA, so that you get the benefit of compound growth over the longest possible time without the headache and expense of taxes.
Once you put the money in an IRA and deduct it that first year (or not deduct it, for a Roth), you’re done reporting it or worrying about taxes for it every year, until you want to take money out.
When you want to take money out, if you’re retirement age, great. I believe there are taxes on what you withdraw, but there would be taxes on whatever you’d have done. If you’re under retirement age, you pay a 10% penalty – which is worth it if you really need the money.
I took money out twice, both times to help cover a house down payment. One time I got all of it back in within 3 months (so it could be considered a rollover); the other time I only got half back in time, but was happy to pay the 10% for that half that I couldn’t get back in, in order to buy the house (which turned out to be a great investment, so the 10% was more than regained.)
Get into the habit of making regular contributions to your retirement. The earlier you start, the better. Length counts more than amount: the amount you end up with is proportional to what you put in, but it goes up exponentially with how long it’s in. It’s not a magic bullet, but it’s the best weapon in the arsenal, by far.
The money I have from contributions I made in my 20’s, while contributions were far smaller than what I was able to make later, amounts to more than the result of what I contributed any two decades since then. I’m 56 now.
If I may step in with a question; I don’t want to start a new thread.
Say I’m wanting to save for a down payment on a house in 10-15 years. I know it’s possible to save your money in the stock market. Is that a prudent thing to do? And do people just buy an index fund, contribute, then cash out?
It’s not. You can make money, you can lose money or you can break even, but the stock market is not a saving tool, it’s an investment tool.
I’m not qualified to give you any kind of financial advice. You may not have meant what you said literally. There’s a strong chance that my reply to your post is going to come across as patronizing or needlessly dickish, but that statement set off flashing lights and klaxons in my head. If you’re young and investing for liquidity in 10-15 years to buy your first home but have no idea how to do so, you really need to talk to a personal finance professional. Saving means little to no risk. It absolutely does not mean “buy an index fund, contribute and cash out.”
I mean no disrespect, whatsoever.
I’ll disagree with Jake - with a 10 - 15 year timeline, the stock market is probably a better place to put your money than a “little or no risk savings tool”- the thing is that you want to move your money from the stock market and into a little or no risk savings tool five years or so before you’ll need it - but not when the market is down (which is why you want all those extra years.)
So if you start buying a no load S&P index fund now, putting in $100 a month or whatever, and in five years you look at it and say “I’m going to need this money in five years” - if its up, you take it out, put it into something nice and insured, if its down - then you have five more years for it to recover - when it does, take it out.
The rationale is that it almost never takes more than a few years for the market to recover from a drop - if you are patient and don’t panic, it will come back. But you need to be able to afford to be patient - which is why you want any money you might need in the next five years in something like laddered CDs or a money market account. (And if you have EXTRA money in safe savings, when the market drops you can go bargain shopping, its like an after Christmas sale for investors).
Both you guys need to do a lot of reading. Wesley - what an traditional IRA gets you is tax deferral - which is way cool since you get to grow what would have been the governments money in your account and then pay taxes later - its the trade for having it tied up. But if you get a 401k at work, you are likely ineligible for an IRA. Max out the 401k at work first. And 59 1/2 is coming a hell of a lot faster than you think it is, trust me.
I know everyone has tons of money, so its easy to both save and invest for both the long term (retirement), the mid term (your house) and emergencies (getting laid off). But ideally, that is what you want to do. You want a tax deferred retirement vehicle (or a Roth, where you pay taxes now, but your gains are tax free when you retire - you are making a different bet), you want to regularly invest for the longish term, and you want enough savings so that if you get laid off, you can last six months - without unemployment payments - at your current standard of living (because cut your standard of living and add in unemployment and you can make it a year or more before you start missing mortgage payments). The least important of these is to regularly invest for the long term. The most important is to get a start on having that short term savings (not the whole thing) and then start funding the retirement accounts. Unless you know you are dying young.
And I’d never pay a financial professional for information you can get from the library. ESPECIALLY never talk to someone who gets paid selling you stuff. If you find an hourly CFP, maybe, the problem being that you can use the few hundred you’ll pay him or her to make a few mistakes and learn. Most of the CFPs I’ve talked to are unimpressive - they should understand things like tax consequences a hell of a lot better than they do (I’ve had two give me completely wrong information of taxation of stock options). In the end - whether you hire someone or not - its YOUR money and any CFP is going to walk away from your loss with some of your money in his pocket. So if you hire one, you need to check their advice and make your own decisions anyway.
I just want to clarify this point. A 401k does not disqualify you from an IRA.
For a Roth IRA: as long you are under the income limits for a Roth IRA, you can contribute up to the maximum in your 401k, and also contribute up to the maximum in your Roth IRA.
For a traditional IRA: You can contribute up to the maximum in your 401k, and also contribute up to the maximum in your traditional IRA; however depending on your income level, the full amount of the traditional IRA contribution may not be tax deductible.
I also have to disagree with using the stock market to save for a down payment. There is just no guarantee of what will happen to that money, and even 10-15 years is too short a timeframe for the market. I would recommend saving in a much safer investment, such as CDs or a money market fund. I know that with current interest rates, they don’t seem like good investments, but they are safe investments, and that’s the prudent thing to do.
Actually, even if you exceed the income limits for a Roth IRA contribution, there is a workaround called a “Backdoor Roth” contribution. It only works if you have a 401k and no traditional IRA account.
The backdoor Roth has nothing to do with 401k plans, it is not necessary to have one.
A bit of background: If your income exceeds a certain level, you may not make a Roth IRA contribution, but you may be able to make a Traditional IRA contribution. You can also convert some or all of your Traditional IRA account to a Roth IRA account. Several years ago, Congress removed the income limit for making this conversion. A backdoor Roth IRA contribution simply refers to the practice of making a Traditional IRA contribution and then immediately converting it to a Roth IRA.
Having a Traditional IRA account isn’t necessarily a bar to doing this. But the conversion may not be tax-free if you have some before-tax money sitting in a Traditional IRA account when you do the conversion.