I recently had someone tell me that they couldn’t make as much money in their IRA or 401K as they could if they just left their investment dollars in a regular taxable account. Huh?
Typical investment places include bank accounts, stocks, bonds, mutual funds, ETF’s. Money saved and invested in these places can be your taxable funds, as well as IRA’s and 401K’s.
The simplest and safest place to put your money is in a bank CD. You will earn a pittance in interest, but your money will be safe. Both your taxable money and your IRA money will earn the same interest rate. At the end of the year, interest earned in your taxable account must be included in your yearly taxable income, but the interest in your IRA will not be taxed.
Likewise, you can purchase $300 worth of stock from Company X with either your taxable money or your IRA money. Let’s say you picked a great stock and your money nearly doubled! You choose to take your profit and you sell Company X for $500.00. You now owe taxes on $200.00 if this was in your regular account. That same $200 profit earned in the IRA will not be taxed.
401k’s work essentially the same way. Generally, there is a more limited investment choice of mutual funds for your 401K dollars which will make an exact comparison a little more difficult. The concept is the same. If a mutual fund goes up; every account that has invested in that fund will go up whether it is a 401K, IRA, or regular account.
Whatever investment you have in a taxable account will be taxed the year you receive that money. This includes dividends and interest that may be reinvested. Whatever investment you have in a Traditional IRA or 401K will not be taxed UNTIL you actually take funds out at retirement. If you have these funds in a ROTH IRA or Roth 401K, you may never pay taxes on them.
So to be clear – whether you invest in regular accounts, IRA’s, or 401K’s, your money will grow at the exact same rate. What changes will be the tax you pay. But that is for a later blog.
OK. Maybe not all. But most. Whether you are just starting out or well into your career the Roth IRA will provide you with an exciting way to save on taxes and ultimately hold onto more of your money. I recommend it as the vehicle to save for that all important emergency fund, first home, college fund, and, of course, retirement. And, let’s face it, unless you plan on kicking the bucket in a few short weeks, who doesn’t need an emergency fund or retirement fund?
The Roth IRA has one awesome characteristic. All monies contributed to your Roth IRA are after tax dollars. That means you pay your tax before you invest it. All earnings from your IRA remain untaxed in your IRA until you withdraw these funds. This includes interest, dividends, capital gains etc. When you withdraw money from your Roth IRA after your 59 1/2 birthday (and your IRA has been open at least 5 years), all these funds will come to you totally tax free. If you withdraw money earlier, then any increase in your Roth IRA is subject to taxes and penalties.
But what about your initial contributions? Because the tax has already been paid on the contribution to your IRA, that amount can be taken out without tax or penalty. Stash your funds in a ROTH IRA and that money will remain available to you whenever you may need it. Any earnings should be left if for the long run, but the original contribution may be taken out in an emergency with no adverse effect (other than decreasing your retirement savings). If you need to tap these funds, simply withdraw the original contributions and leave the earnings for your retirement. You will not have any penalty or additional tax to pay.
At the end of the year, you will receive a 1099R stating the amount of money that you have withdrawn from your account. This must be listed on your 1040 federal tax form. But you also get to list the original amount of your contribution. This is known as your basis in your IRA and is simply the total money that you had invested and left in your Roth IRA. If necessary you can withdraw funds more than once from your IRA. Simply reduce your basis by the amount you have withdrawn in the past. As long as you have basis, a pre-retirement withdrawal will not be included in your taxable income.
IRAs and retirement funds are not to be tapped lightly. They are meant to provide security in your twilight years. The discipline of putting money aside for fifty years is daunting…you may be hesitant to commit funds for such a long time. The Roth IRA encourages this savings by leaving a back door open to tap these funds. Through the Roth IRA you will have taken your first step towards financial independence.