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Why you CAN and SHOULD contribute to an IRA

People always say you should save money in an IRA. Most people know they should contribute to an IRA, however only about 1/3 of households make contributions to either a Roth or a Traditional IRA. I believe having some background, additional information and context would help more people save in their IRA accounts.


Background


There are two types of Individual Retirement Accounts (IRA), the Traditional IRA and the Roth IRA. The Traditional IRA allows you to make contributions to the account and in many cases, take a tax deduction for that contribution. The account grows tax deferred, meaning you do not pay taxes on the growth and income on an annual basis. Money can be withdrawn after 59 ½ without a penalty, and you are required to take money out after 70 ½. When you take money out of the Traditional IRA after age 59 ½, you must pay ordinary income tax on the withdrawals. If your income is above the threshold, your contributions are not deductible. This is called a Nondeductible IRA.


The Roth IRA allows you to make contributions to the account on an after-tax basis. This means you do not get a deduction when you make the contributions. However, when you withdraw money from this account, the principal and growth will be tax free as long as the money has been in the account for more than 5 years. Also, you are not required to take money out of the Roth IRA at age 70 ½. This account is very helpful in managing your taxes in retirement. If your income is above the threshold, you cannot make contributions to the Roth IRA. However, there is a loophole, that many people call the Backdoor Roth IRA. This is where you put money into a Nondeductible IRA and then convert it immediately to a Roth IRA. This circumvents the income limitations.


This means everyone can contribute to some kind of IRA as long as they have earned income.


Savings Requirements & Impact


If you are saving into an IRA, there are maximums based on the tax code, however, you can put in less. There are people who believe they have to save the maximum or nothing at all. Put away as much as you can in these accounts.

The reason to utilize these accounts, aside from the basic answer of your future needs, is for the tax advantages. If you are in the 24% tax bracket, and you earn 8% on your investment, in an IRA, you keep that 8% and it grows until you take it without taxes. The same investment in a taxable account, if all the earnings are short term gains, it lets you keep 6.08% (8% Gain – 1.92% in Taxes). This is an extreme example, but the point is unchanged. If you can avoid paying taxes on your growth, you will have more money. If you invest $10,000 and earn 8% a year, after 20 years you will have $46,610, pay 24% in taxes and you have $35,424. If you invest $10,000 and earn 6.08% per year, after 20 years you will have $32,620. The difference is huge! Especially if you continue to contribute to these accounts.


In conclusion, there is an IRA for EVERYONE that has earned income. With or without a deduction now and regardless of the taxes in the future, you will likely have more money in your account through the tax deferral. If you are a part of the 2/3 of the population that is not contributing to your IRA, help your future self by starting to make contributions. #Retirement #RothIRA #IRA #TraditionalIRA #FIRE


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© 2018 by Roshan Loungani, CFP®, CRPC®.  Vienna, Virginia

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