[Note: This Letter is an educational publication designed to provide a general background for understanding IRAs. It is not a substitute for professional tax advice. Readers considering the implementation of an IRA are encouraged to consult with a qualfied financial advisor or tax professional. This Letter references tax rates and IRA parameters for 2016. If you are reading this after 2016, then new rates and parameters may apply. You can check the True Vine Letter IRA archives for more recent updates or visit the Internal Revenue Services (IRS) website at irs.gov. IRS Publications 590-A (Contributions to Individual Retirement Arrangements) and 590-B (Distributions from Individual Retirement Arrangements) cover IRAs and they are usually updated on an annual basis. The IRS Tax Map for IRAs is also a helpful resource.]
An Individual Retirement Account (IRA) is a type of financial account that provides unique tax saving advantages that vary depending upon the specific type of IRA. The IRA was originally created by the U.S. government in 1975 to assist workers in saving for retirement.
Before we dig into the details on IRAs, it is important to realize that we should not even have them in the first place. Why? Because savings and investment should never be taxed. Americans should never have to pay tax on interest, dividends, capital gains, and estates. It is counterproductive to economic growth (among other things). We should simply just have financial accounts—bank, brokerage, mutual fund, and so on. Can you imagine how much paper work, tax reporting, and related headaches could be eliminated? Can you imagine how much simpler the overall investment process would be?
This is what happens when God is being rejected and freedom is being lost. The gods Americans are increasingly turning to promise to take care of them, but ultimately oppress them.
Overextended government creates a problem (tax on investment) and then ends up creating more bureaucracy to make the administration of the problem they created in the first place even more complicated. Then they create IRAs to “help” Americans save for retirement. Remember this when you listen to a debate or go to the polls. In the rest of this Letter we will plunge into the administrative abyss, but remember, there is still a way out.
Making Your Investments Go Further
The fundamental incentive for an individual to use an IRA instead of a regular bank, brokerage, or other financial account is tax savings. What taxes can an IRA help us to avoid or put off? Here is a list of the most common taxes that apply to saving and investing:
- Interest Income - taxed at your regular income tax rate
- Short-Term Capital Gains (holding period < 1 year) - taxed at your regular income tax rate
- Long-Term Capital Gains (holding period > 1 year) and Qualified Dividend Income - 0% rate for those in the 10% or 15% tax brackets; 15% rate for those in the 25%, 28%, 33%, or 35% tax brackets; 20% rate for those in the 39.6% tax bracket
- Unqualified Dividend Income - taxed at your regular income tax rate; an additional 3.8% Medicare surtax applies for single filers with a Modified Adjusted Gross Income (MAGI) > $200,000 and married couples (filing jointly) with a MAGI > $250,000
- Gains on Collectibles (including gold & silver) - taxed at your regular income tax rate not to exceed 28%
Eliminating or deferring these taxes over an extended period of time can really add up. Consider the following hypothetical example of Peter and Paul.
Peter and Paul are both professional lobstermen that have been in the business for twenty years. They both started when they were 20 years old, so they are both now 40 years old. They both work for Red Claw Enterprises, based out of Bar Harbor, Maine, which does not offer a company retirement plan for its workers. They are equally successful. They both took home about $75,000 in income during 2016. They are also both savers. Since 1996, when they started working for Red Claw, they have both been putting money away. The only difference between the two is that Peter has always been more tax savvy. After conducting his own research, he began putting his savings into a Traditional IRA after learning that (1) the contribution was tax deductible and (2) that there was no tax on the dividends and capital gains that his investments earned. He would only have to pay tax on the distributions he eventually took from the IRA during retirement. Paul put all his savings into a regular taxable brokerage account.
How did Peter fare compared to Paul over the last 20 years? First, a few parameters:
- at the beginning of each year (1996 to 2015), both contributed the equivalent of the maximum allowable IRA contribution to their investment (this was $2,000 from 1996-2001, $3,000 from 2002-04, $4,000 from 2005-07, $5,000 from 2008-12, and $5,500 from 2013-15).
- both were in the 25% marginal income tax bracket
- 20% capital gains and dividend tax rate
- 10% average annual returns
Twenty years of non-taxable IRA investing for Peter allowed him to accumulate $191,562, which is $35,346 more than the $156,216 Paul accumulated in his taxable account. However, this does not tell the whole story. Peter would have saved additional money each year in taxes, because his annual contributions were tax deductible. Assuming he invested this additional savings in a taxable account, he would have an additional $39,054. This would give Peter a combined total of $230,616, which is $74,400 more than Paul. Thus, Peter would have accumulated the equivalent of almost an entire years salary more than Paul.
To be fair, Peter will eventually have to pay income tax on his distributions, however, he is only 40 years old so the compounding can continue for many more years. There is also the potential to convert a portion or all of the Traditional IRA to a Roth IRA at a lower tax rate, depending upon his future circumstances.
We can see from this example that using an IRA enables the long-term investor to further harness the power of compounding in our overtaxed world. If one assumes higher rates of return and/or higher marginal tax brackets, the compounding is amplified even further. Also, the earlier one starts, the better. In a future Letter, I plan on discussing how inter-generational planning can be used to take advantage of this tax deferred compounding.
The most common misconception I come across regarding IRAs is the idea that they are a type of investment. An IRA is a type of account, it is not a specific type of investment. The return achieved by the IRA depends upon the investment(s) held in the account. An IRA is not a specific investment that promises a certain rate of return, like a certificate of deposit (CD) offered by your local bank.
An IRA account can be held with a bank, brokerage, credit union, life insurance, mutual fund, or similar financial company approved by the IRS to act as a trustee or custodian. The IRA can hold investments in various types of bank deposit products (e.g., CDs), mutual funds, exchange traded funds (ETFs), stocks, bonds, and annuities. An IRA cannot be invested in life insurance or collectibles (except for certain kinds of coins and bullion).
As the name implies, Individual Retirement Accounts are for individuals not for married couples. Each spouse will have their own separate account(s).
The remainder of this Letter will discuss the standard Traditional and Roth IRAs, however, if you are a small business owner, keep in mind that there are additional types of IRAs available for you.
Traditional versus Roth IRAs
There are two primary types of IRAs, the Traditional and the Roth. A Traditional IRA is generally funded with pre-tax contributions (income you have not paid tax on yet), whereas the Roth IRA is funded with after-tax contributions (income you have already paid tax on). The Traditional IRA offers tax deferred compounding of investment earnings and gains, whereas the Roth IRA offers tax free compounding of investment earnings and gains when held for at least 5 years (more on this later). You are required to begin taking distributions from Traditional IRAs by April 1 of the year following the year you reach age 70 1/2. You are not required to take distributions from a Roth IRA during your lifetime.
Traditional IRAs are generally more beneficial for individuals expecting to be in a lower tax bracket in the future, such as their low income retirement years, whereas Roth IRAs are generally better options for individuals expecting to be in a higher tax bracket in the future. The Traditional IRA is geared towards paying taxes later, whereas the Roth IRA is geared toward paying taxes now.
Choosing between a Traditional and a Roth IRA is never as straight forward as deciding when to pay income tax. Roth IRAs may be more advantageous for young parents who want to tap the accounts down the road for education expenses. Another consideration that will become increasingly important in the years to come, is the value of the dollars you are being taxed on (i.e., their purchasing power). If the value of the dollar is going to be eroded by inflation, then it may be better to get the tax deduction now, and thus, have more pre-depreciated dollars now to invest in assets that will allow you to maintain your purchasing power. With this strategy, you can defer the income tax and pay it later with depreciated dollars! This aspect of IRA planning is rarely considered by financial advisers or financial planning websites.
To contribute to any IRA, an individual (or his or her spouse) must have taxable compensation of at least as much as the amount one wants to contribute. Compensation includes wages, salaries, tips, professional fees, bonuses, other amounts received for providing personal services, commissions, self-employment income, alimony, separate maintenance payments, and nontaxable combat pay. Compensation does not include earnings and profits from property, interest and dividend income, pension or annuity income, deferred compensation, and income from a partnership for which you do notprovide services that are a material income-producing factor.
The only other requirement to contribute to a Traditional IRA is that one must be under the age of 70 1/2 at the end of the year the contribution is made.
There is no age limitation for Roth IRA contributions. The only other requirement to contribute to a Roth IRA is that modified adjusted gross income (MAGI) must be less than the following (depending upon your filing status):
- $193,000 for married filing jointly or qualifying widow(er)
- $10,000 for married filing separately and you lived with your spouse at any time during the year (if you did not live with your spouse at any time during the year, your status is considered single for this purpose)
- $131,000 for single, head of household, or married filing separately and you did not live with your spouse at any time during the year
If your MAGI falls within a certain threshold approaching your limit (between $10,000 to $15,000, depending upon your filing status), then the amount you can contribute to your Roth IRA is reduced. If you are filing married filing jointly or qualifying widow(er), then you can contribute the full amount if your MAGI is less than $183,000. If you are filing single, head of household, or married filing separately (did not live with spouse at any time during year), then you can contribute the full amount if your MAGI is less than $116,000.
For 2016, and individual who will be less than 50 years old at the end of the year can contribute up to $5,500 to either a Traditional or Roth IRA. An individual who be at least 50 years old at the end of the year can contribute up to $6,500. Contributions can be made to both a Traditional and a Roth IRA as long as the combined amount does not exceed the $5,500 or $6,500 limit.
Under no circumstances are Roth IRA contributions tax deductible.
If you are single and do not have an employer provided retirement plan or married and neither you or your spouse is covered by an employer retirement plan, then contributions to a Traditional IRA are always 100% tax deductible.
If you do not have an employer provided retirement plan, but your spouse does, then your contribution is fully tax deductible if your MAGI is $183,000 or less (married filing jointly) or $10,000 or less (married filing separately and did not live with your spouse at any time during the year). Your contribution is partially tax deductible if your MAGI is more than $183,000 but less than $193,000 (married filing jointly) or less than $10,000 (married filing separately and you lived with your spouse at any time during the year). If your MAGI exceeds your applicable threshold, then your contribution is not deductible.
If you do have an employer provided retirement plan, then your contribution is fully tax deductible if your MAGI is $61,000 or less (single or head of household) or $98,000 or less (married filing jointly or qualifying widow(er)). Your contribution is partially tax deductible if your MAGI is more than $61,000 but less than $71,000 (single or head of household), more than $98,000 but less than $118,000 (married filing jointly or qualifying widow(er)), or less than $10,000 (married filing separately and you lived with your spouse at any time during the year. You are considered single if you did not live with your spouse at any time during the year.) If your MAGI exceeds your applicable threshold, then your contribution is not deductible.
Taxation of Distributions
When determining whether or not IRA distributions are taxable, it is important to distinguish between the amount of the distribution that comes from your initial contribution(s) and the additional amount (if any) that comes from the earnings and gains produced by the investments the initial contribution(s) went into. Keep this in mind as you read the following paragraphs.
Distributions from a Traditional IRA representing deductible contributions are taxed as ordinary income. Any portion of a distribution from a Traditional IRA representing nondeductible contributions is not taxable, only the earnings and gains generated by the contributions (if any) are taxed (as ordinary income).
The portion of a distribution from a Roth IRA representing contributions is never taxable. Investment earnings and gains are not taxable if (1) you are over age 59 1/2 and (2) the distribution is more than 5 years after you began contributing to the Roth IRA. Earnings and gains are also subject to a 10% penalty if you are under the age of 59 1/2.
There is an additional caveat with Roth IRAs to be aware of. If you rollover a qualfied retirement plan (e.g., a 401(k)) to a Roth IRA or convert a Traditional IRA to a Roth IRA and then take a distribution from the Roth IRA within 5 years and before you are age 59 1/2, then you will have to pay a 10% penalty on the entire amount (unless an exception applies).
Individuals with an employer retirement plan who have too high of a MAGI to contribute to a Roth IRA can still make nondeductible contributions to a Traditional IRA. This gives them the opportunity for tax deferred compounding on their investment earnings and gains for potentially many years.
Individuals making nondeductible contributions must report them to the IRS onForm 8606 when filing their taxes. Failure to file the form may result in a $50 penalty. Even worse, if nondeductible contributions are never reported, the eventual distributions may be fully taxable (not just the earnings and gains).
If you are going to make nondeductible contributions, it is best to open a separate IRA just for these amounts, instead of commingling them with deductible contributions. This can reduce accounting headaches down the road.
Individuals who only have a Traditional IRA(s) from nondeductible contributions (i.e., they do not have any IRAs from deductible (pre-tax) contributions) can later convert to a Roth IRA. They would only have to pay tax on any investment earnings or gains, but if the conversion is done relatively soon, these would likely be minimal. Once the assets are in a Roth IRA, they can have entirely tax free distributions, if they meet the previously discussed requirements, and/or tax deferred compounding can continue with their heirs before they are required to take distributions over their lifetime.
Thoughtful Planning is Essential
I have met with a lot of individuals and married couples over the course of my advisory career. I have found that in most situations, there is room to either save taxes and/or avoid early withdrawal penalties with just a little bit of planning.
I would welcome the opportunity to review your financial situation with you. I am a listener, not a salesman, and I never charge for financial consultations. If you are interested, click the button below to get started.
Joshua S. Hall, ChFC
The True Vine Letter is a publication of True Vine Investments, the investment advisory business of Joshua S. Hall, ChFC, a Registered Investment Adviser in the U.S.A. The information presented in The True Vine Letter is provided for educational purposes only and not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities, investment products or other financial instruments, nor to constitute any advice or recommendation with respect to such securities, investment products or other financial instruments. The True Vine Letter is prepared for general circulation. It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person who may read this letter. You should independently evaluate specific investments and consult a professional before making any investment decisions.
All data presented by the author is regarded as factual, however, its accuracy is not guaranteed. Investors are encouraged to conduct their own comprehensive analysis.
Positive comments made regarding this article should not be construed by readers to be an endorsement of Joshua S. Hall's ability to act as an investment adviser.