Everything You Need to Know about IRAs: The Definitive Guide

This is not investment advice, ok? 

You've probably heard your accountant or that one friend who totally has their shit together talk about how you should be saving for retirement in an IRA. And like a good adult, you probably make all the right noises at the right times to suggest you understand what the hell they're talking about. In case you've been living a lie because you don't really know what the hell an IRA is, I'm here to free you from the shackles of your own confusion. 

So let's go balls deep into the non-sensical world of IRAs.

 

What is an IRA?

Well, I'm glad you asked. The IRA is short for individual retirement account. It is a forced savings account that is specifically designed to help workers save some of their earned income for their old selves.

I specifically said earned income because only earned income can be contributed into an IRA. Earned income is defined as wages, salaries, tips and other kinds of claimed taxable income produced while working for someone else or yourself. 

So, for example, if you only received gifts from your rich friends and family and distributions from your trust fund, none of that money is earned income. So you can't contribute it to an IRA. 

 

How to open up an IRA

First you choose the platform. It's like choosing where you want to have website hosted. You can choose Squarespace which has it's pros and cons or you can buy your domain at Hover.com and then build it using Wordpress. These variations exist when it comes to the investment platform you choose.

Here are some options for platforms: 

Betterment. They have lower fees, it's easy to open up your account and easy to fund it, it's easy to choose how you want to invest. All around, it's one of the best user experiences I've seen an investment company provide. The downfall is they don't offer all types of accounts like SEP IRAs for businesses with more than one partner. Although their investment offering is limited investment selection (only EFTs) I don't really think that's a downfall for retirement investing.

Fidelity. Fidelity has been around for a long them and a lot of people invest with them, making them one of the biggest and most trusted investment platforms. They have a lot of investment options, it's not just limited to EFTs and they offer all the different types of investment accounts . Their technology has also definitely been improving.

Wealthfront. Wealthfront is like a Betterment. The same pros - low cost, easy to use, great interface. They have excellent tools to help you understand your investments. 

Vanguard. Vanguard is like a Fidelity. They've been around for a long time and lots of people invest with them so they're huge and trusted. Vanguard is also getting better with their online interface and technology tools. They support all account types, but sometimes it's still annoying because they'll make you complete a PDF application for a SEP IRA with more than one business partner. 

 

How to put money into your IRA? How much does it cost?

With most platforms, you can easily transfer money from a current bank account or existing IRA or by rolling over money from a 401(k) from a previous employer.

Costs depend on the platform you choose.

 

Make sure you invest the money that you put into your IRA.

After you choose your platform, you fund your account. Funding your account means putting cash from your checking or savings account into the IRA. Then you need to invest it by buying shares of investments. If your account is at Betterment or Wealthfront, you'll be invest in EFTs. If you're at a more traditional platform you can choose to invest in cash, CDs, stocks, bonds, mutual funds, exchange-traded funds, index funds, etc.

 

The Two Types of IRAs: Traditional + Roth

The difference between the two is a matter of when your receive tax benefit. In other words, tax benefit is a matter of timing. 

The Traditional IRA

With the traditional IRA, you receive the tax benefit now. The money you put into your account (the industry calls this contributions) made today to a traditional IRA are tax-deductible. This means your contributions help you to reduce your taxable income. But when your old self takes money out (future withdrawals), you'll have to pay income taxes on the money you pull out.

Anyone may contribute to a traditional IRA regardless of how much you earn. The earliest you can start taking money out as withdrawals is 59 1/2. If you take money out before then, you'll be subjected to a 10% penalty (in addition the income taxes you'll pay on the withdrawal). The penalty is why it's a forced savings plan. 

For the 2017 tax year, you can contribute up to $5,500 in a traditional IRA. If you are 50 or older, you can make an extra “catch-up” contribution of $1,000.

There is an age limit to traditional IRAs, you must be younger than 70 1/2 to open one. 

 

The Roth IRA

Contributions to a Roth IRA are not tax-deductible now. Instead, when you begin to take money out from your Roth IRA, the withdrawals will be tax-free beginning at age 59 1/2 (as long as it’s been at least five years since your first contribution).

Like a traditional IRA, you can contribute up to $5,500 in a Roth. If you are 50 or older, you can make an extra “catch-up” contribution of $1,000. 

Here are the main differences:

Post-tax dollars. The money you put into your Roth IRA must be post-tax dollars. This means, you already paid taxes on the money. An example of post-tax dollars is your paycheck after taxes.

You might not be able to contribute to a Roth if your income is at a certain level.  If you are married and filing taxes jointly, the IRS says you can fully contribute to a Roth IRA, as long as your adjusted gross income (AGI) is no more than $186,000. Single filers must earn less than $118,000 to contribute up to the limit. Check with your accountant on this.

You can pull out contributions without a penalty, but there are parameters. Once your account has been open for five years, you can withdraw contributions (the amount you put in the account) penalty-free. But if the account has had some earnings and you withdraw earnings before you're 59 1/2, then you have to pay the penalty on those earnings. Does that make sense?

For example, lets say you contributed $5,000 and there are $2,000 in earnings. The account has been open for ten years and I'm 29. I can take a withdrawal for the first $5,000 without having to pay the 10% early withdrawal penalty. I'll still have to pay income taxes though. But if I go beyond what I initially contributed, before retirement age (59 1/2), I'll have to pay the 10% fee.

Unlike a traditional IRA, there is no age limit to contribute to a Roth.

Remember, the broad stroke difference between the traditional and Roth are with the traditional IRA, you put in pre-tax dollars for a tax benefit today. With the Roth, you put in post-tax dollars for the benefit later.

 

What Should You Choose? Roth vs. Traditional

If you expect that (read: you can predict the future) you'll be in a lower tax bracket in retirement, traditional all the way, you'll get the tax benefit in the years that you're in the higher income tax bracket. The other side of the same coin is, if you expect to be in a higher tax bracket in retirement, go with Roth because you'll get to withdraw the money tax free.

If you're excluded from the traditional because you are such a baller who makes too much money, then your choice is made for you.

If you already have a 401(k) or Traditional, you might want to open up a Roth to diversify. So some of your money in retirement is taxable and some is not.

And lastly, if you need more liquidity, meaning, you need to access your cash, you might want to consider the Roth because you can withdraw contributions penalty-free once the account has been open for five years.

 

IRA vs. 401(k): Which is better?

If you have an employer who is willing to match any portion of your your 401(k) contribution, and you can afford to contribute, you should absolutely, without a doubt contribute to your 401(k). The employer contribution is free money so that makes it "better".

If you're already putting the maximum amount that you can contribute to a 401(k) and you want to put away more, then an IRA is great. 

 

The IRA for the Self Employed

If you're a business owner or a freelancer, you have the option of the SEP IRA (SEP stands for Simplified Employee Pension). What I love about the SEP is that you can contribute a shit ton (technical term) of money compared to a regular IRA. The rub is that you have to earn a shit ton (technical term) of money in order to do that. You can contribute up to 25% of your compensation OR up to $54,000 in 2017.  This is a much larger amount than with traditional IRAs, like more than 9 times larger. 

SEPs follow many of the same rules as traditional IRAs. You can open one up for yourself quite easily. A SEP can be costly if you have employees. If you have a SEP and employees who are eligible to participate in the SEP, you are required to make contributions for each employee. The contribution is a uniform percentage of pay for each employee, but you don’t have to make contributions every year, so there is  some flexibility when business conditions vary.

Employees must be included in the SEP plan if they have: attained age 21; worked for your business in at least 3 of the last 5 years; received at least $600 in compensation (in 2016 and 2017) from your business for the year.

If there are multiple business owners who are on payroll, it can be a thorny equation to figure out; your accountant should be riding shotgun to help you navigate through.

 

The More Obscure IRAs: The Simple + Self Directed

SIMPLE IRA Plan

The SIMPLE IRA plan is available if you have 100 or fewer employees. The most an employee can contribute to this plan is $12,500  ($15,500 if age 50 or older) for years 2015 - 2017.

Trigger warning, this gets dense: You must either match your employees’ contributions dollar for dollar–up to 3% of each employee’s compensation–or make a fixed contribution of at least 2% of compensation for each eligible employee. Alternatively, the 3% match can be reduced to 1% in any two of five years. Each employee who earned $5,000 or more in any two prior years, and who is expected to earn at least $5,000 in the current year, must be allowed to participate in the plan. 

Set up is easy with a SIMPLE IRA and the administrative costs are relatively low. You just fill out a short form to set up the plan. A traditional platform like Fidelity or Vanguard can walk you through this.

 

Self-Directed IRAs

Self-directed IRAs are in a category all their own. This type of account isn't as limiting in terms of what an investor can invest in unlike traditional IRAs. This alternative account allows investors to have more a broader range of assets like private equity, real estate, precious metals, foreign companies, even race horses. This allows an investor to diversify their assets and have some creativity when it comes to building their investment portfolio.

 

There you have it, folks. Way too much information about IRAs.