What is an IRA?

So we’ve discussed how to invest and what you can invest in, but what investment account should you use to purchase said investments? Allow me to introduce two of my favorites, the Traditional and Roth IRA.

Good morning, hope your first full work week after that sweet, short 4th of July work week hasn’t been too painful. 

To start, let’s break down the acronym. An IRA is an Individual Retirement Account. An IRA is one of many tax-advantaged investment accounts used specifically for retirement savings. The US government introduced the IRA in the ‘70s as a way to incentivize investing for retirement, offering tax benefits to help reduce your tax burden when investing.

IRAs are available to all people who earn an income (not including payments from Social Security, rental properties, or any other income the IRS doesn’t consider “earned”), as well as spouses of income-earners who file taxes jointly. In 2023, those under age 50 can contribute up to $6,500 a year to an IRA, and those 50 or older can contribute up to $7,500. This limit generally increases every few years or so (depending on inflation). The total amount you contribute to both a Traditional and/or Roth IRA can’t exceed $6,500/7,500.

One major perk of the IRA is that you can open an IRA in any brokerage that supports them, giving you the freedom to buy whichever funds you want to invest in. Fidelity, Vanguard, and Schwab (my three favorite brokerages) all allow investors to invest within an IRA.

Before we get any further, let’s clear up a common misconception. An IRA is not an investment, it is an investment account. Stocks, bonds, ETFs, and index funds are investments—they grow in value and make you money when you sell them for more money than you bought them for. An IRA is simply an account where you can purchase and hold these assets, while saving you money in taxes compared to taxable investment accounts. Investments make you money. Tax-advantaged investment accounts (like the IRA) save you money in taxes.

So the process for buying an index fund within an IRA looks like this:

1. Open an IRA within a brokerage (like Fidelity, Vanguard, or Schwab)

2. Link your checking account to your IRA, allowing you to transfer money to it

3. Transfer money from your checking account to your IRA

4. Invest the money you just transferred to your IRA in an index fund (or ETF/stock/bond/etc.)

*I want to AGGRESSIVELY EMPHASIZE point #4, because many wanna-be retirees have been royally screwed by messing this part up. Transferring money to your IRA alone is not investing. You have to transfer money to your IRA, and then invest that money in something. If you don’t invest it, it’ll sit in a money market account earning a 0.01% return annually and you’ll look at your money at age 65 wondering why it’s never grown. Don’t be that guy/gal.

Roth vs. Traditional IRA (Tax Benefits)

There are four types of IRAs (two of which we’ll ignore for now), all falling under the umbrella of either tax-deferred or after-tax. The two primary types of IRAs are the Traditional IRA and the Roth IRA, each with their own unique tax benefits.

Traditional IRAs are tax-deferred, meaning you can deduct the money you contribute to them from your taxes (up to a certain income limit). This money grows tax-free until retirement, when your withdrawals are then subject to federal and state income taxes. Contributing $6,500 to a Traditional IRA would reduce a taxable income of $50,000 to $43,500, meaning you’d only pay taxes on $43,500 of your income. This lowers your current tax burden and frees up additional money to invest now. You would receive these tax savings as an annual tax refund.

Roth IRA contributions are made with after-tax dollars, meaning you pay federal and state income tax on your contributions upfront but take advantage of tax-free withdrawals when you retire (both for the money you contributed and the amount it’s grown AKA capital gains). Contributions to a Roth IRA don't reduce your taxable income for tax-filing purposes.

This chart outlines the general tax differences between the Traditional and Roth IRA:

The last similarity between Traditional and Roth IRAs is that all capital gains (the growth of your money) and dividends (the distribution of a company’s earnings to its shareholders as a thank-you for investing) are tax-free while your money is invested, as long as your money stays in the IRA until you reach the federal retirement age of 59.5. Capital gains and dividends within regular taxable investment accounts are both taxable.

That's generally where the similarities end. Here’s where the Traditional IRA and the Roth IRA differ.

Contribution Income Limits

Traditional IRA: There are no income limits to contribute to a Traditional IRA, although there are income limits for deducting IRA contributions from your taxable income. Check out the IRA deduction limits here.

Roth IRA: Single tax filers who earn over $153,000 and joint filers who earn over $228,000 a year are prohibited from contributing directly to a Roth IRA. However, you can legally bypass this restriction through what’s called a Backdoor Roth IRA, which we’ll go over in a future newsletter (the IRS HATES this one simple hack!!!).

Tax Brackets

Traditional IRA: Your money is taxed at whatever future tax rates are when you withdraw the money in retirement, for better or worse.

Roth IRA: Your money is taxed at current income tax rates, regardless of tax bracket fluctuations in the future.

Required Minimum Distributions (RMDs)

Traditional IRA: Traditional IRAs require you to begin withdrawing money from them at 73 years old until your IRA runs out of money or you die. This calculator can help you determine how much money that is. When you die, any leftover funds in your Traditional IRA will be subject to RMDs when transferred to a beneficiary. There’s a 25% penalty for failing to withdraw the required amount of money. Yikes.

Roth IRA: Roth IRAs don’t have RMDs, since you’ve already paid taxes on your contributions. When you die, any leftover funds in your Roth IRA will be subject to RMDs when transferred to a beneficiary.

Early Withdrawals

Traditional IRA: You’ll incur a 10% penalty (on top of the income tax you’ll owe) on all Traditional IRA withdrawals before age 59.5. But fear not, there’s yet ANOTHER legal hack to access this money before 59.5, penalty-free, called the Roth Conversion Ladder (the IRS HATES this one simple hack even MORE!!).

Roth IRA: You can withdraw any contributions you make to a Roth IRA at any age for any reason. You’ll incur a 10% penalty on any gains withdrawn before 59.5, with a few exceptions. Withdrawals of Roth IRA gains are subject to income tax if it has been less than five years since you first contributed to the IRA.

Just like that, you’re now a master of the Roth and Traditional IRA. But which is better?

Everyone’s favorite answer—it depends. A simple way to decide which one you should use to invest depends on how you answer this question: Do you think your tax bracket will be higher now or when you’re retired? If you think you are in a higher tax bracket now, consider using a Traditional IRA. If you think you will be in a higher tax bracket when you are retired, consider a Roth IRA. There are other factors worth considering when making this decision, but neither option is a bad one. Whichever route you go, both a Traditional and Roth will save you money on taxes when compared to a non-tax advantaged account. Pick one and use it, you won’t regret it.

Call to Action:

Evaluate whether the Roth or Traditional IRA is best for you. Open one within your brokerage of choice and invest $10 in an index fund or ETF of your choice. The hardest part of investing is getting started!

What We’re Reading/Watching/Listening To:

Youtube Channel: UpFlip. Want to learn how to make $12,543 a day by owning some vending machines or starting a pressure washing business?? Look no further. This channel gets my entrepreneurial juices flowing.

Debrief on Deck

Next week, Wilson will continue the home-buying series. Should you buy or rent? Did Wilson fix the holes in his roof or splurge on Yankee Candles during Prime Day? Stay tuned to find out.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (Twitter, Instagram, Threads).

Until then, stay the course.

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