Before we head to the races, IRA, what does it mean? If you're looking for the Jeopardy answer, then what is an Individual Retirement Account? Ding ding ding! Winner winner chicken dinner!
These IRAs can be used in addition or supplemented for retirement accounts. But before we dive into this jello-pudding, don’t forget to follow us on our Facebook Page where we give stuff away for free. Okay, jello-pudding time.
How do you sign up for an IRA? Where do you go? Can you do it on your own or do you need a Financial Advisor? Let’s attempt to take a bite out of this elephant.
You can go to a Financial Advisor but you don’t need to. If you already have one, it makes sense talking to them first before jumping in with your socks on. But honestly, it’s not as complicated as dating your best friends ex. Let me explain. You can open an IRA at pretty much any financial institution:
Vanguard (I personally use)
Or pretty much any bank, but I wouldn’t recommend it. (I’ll explain why in a future episode or article)
To open an account, you need to go through all the nonsense that any account set-up would ask. You know, that peanut butter and eggs nonsense combo I’m talking about (don't knock it until you try it): user name, password, address, email, phone number, etc.
You may even be prompted to enter your banking information, but that's usually after your account is set up and you begin to select your investments. Once that's filled out, it’s time to choose Roth or Traditional. There are a ton of options you CAN choose, but for now, let’s focus on these two.
Let’s start off with the Roth Daddy himself.
Roth contributions are made with after-tax money. This means that The Man, I mean government, has already stolen, I mean taxed you. Okay I’ll stop. Whatever's left over is the money you see when you receive your paycheck. I must state, this example is for W-2 employees as compared to 1099.
Any earnings from your account will grow tax-free (meaning the interest or money you make in the account will not be taxed, by The Man). Think about it, anytime you make money, you pay taxes. Whether it’s your paycheck, savings account, winning at the casino or lottery, even those under-the-table side jobs, you need to claim that as income. But, this magical rule states that all the money you’d gain from the account is tax-less; A.K.A. you don’t pay taxes on it. That’s doper than the front page of High Times.
If we remember anything from what Outkast taught us, what’s cooler than being cool? Not ice cold, but withdrawing your contributions tax-free and penalty-free, any time, for any reason (Reminder: contributions are money you put in).
Earnings on the other hand, can be withdrawn without taxes or penalties as long as they’re eligible. This is not something we want to do. We want the account to grow bigger than South Korea’s BTS fanbase. But if you NEED to withdraw your earnings you can, but you might get hit with taxes and penalties unless you meet certain criteria (that eligibility I mentioned above). And trust me, those penalties hit harder than Chuck Liddell’s roundhouse. If interested, I have linked the early withdrawal criteria for your reference. As a blanket statement, if you make withdrawals before age 59½, on earnings, you'll have to pay taxes plus an additional 10% penalty. That's a math equation we don't want to touch like MC Hammer.
Too good to be true? What’s the catch? There are certain criteria you need to meet in order to open an account as well as how much you can contribute.
How much can contribute?
You can contribute a maximum of $6,000 for the 2020-2021 year. That’s the max, but no one will talk crap behind your back if you contribute less. Extra points if you’re older than 50, you my friend, can contribute $7,000. You may be thinking to yourself one of three things:
That’s too much money
What am I having for dinner?
Regardless, the amount can change. In 2018, the maximum contribution limit was $5,500. Not a soul other than Ms. Cleo knows what the future will hold.
Am I eligible to open a Roth?
There are income limits in order to contribute to a Roth that are set by the Internal Revenue Service (IRS). In 2020, the limits are:
$124,000 if filing single
$196,000 for married filing jointly
If you make more than this, and depending on your situation, you can not open a Roth.
If you are ineligible to open a Roth, I have the GameShark and cheat codes you're looking for. There are ways around this ineligibility issue such as a Backdoor Roth. If interested, I have a How To Set Up a Backdoor Roth IRA link you can read.
If you are married and meet the income requirement, both you and your spouse can open a Roth. If you take advantage of that and your situation allows, that's $12k a year you can contribute.
Required Minimum Distributions (RMDs)
Three words: Required. Minimum. Distributions. What’s that you ask? A Required Minimum Distribution or RMD is a specific amount of money that the government makes you withdraw from your IRA or IRAs when you reach age 72. The exact number varies. To find this majestic number, you can use a RMD Calculator (yes this is a real thing. Or, if you have a Financial Advisor, you can ask them). Your RMD is based on your age, account balance, beneficiaries, and other factors. If you have multiple IRAs, you must calculate each account individually but you can take the total majestic number from one or a combination of IRAs.
Why is this a thing?
To ensure that people don’t accumulate retirement accounts, defer taxation, and leave retirement funds as an inheritance. Instead, the government wants to force the holder to withdraw at least some of the funds as taxable distributions while they're still alive (facepalm). The government wants theirs and wants you to spend money to help bolster the economy. Well guess what?! Since we’re talking about a Roth, none of this matters. If you have a Roth, there are no RMDs! Period. Feel free to have a money hoarding party for as long as you want!
The Lettuce Wrap on the Roth
Contribution limit: $6k or $7k
Grows tax free
CAN withdraw CONTRIBUTIONS penalty free
Contributions NOT tax deductible (we’ll cover this in a moment)
Let’s Tickle Tackle the Traditional IRA
But first, don’t forget to subscribe to our monthly newsletter at BudgetsandBrews.com for our latest podcasts, beer reviews, finance articles, and youtube videos. Now, back to the show.
Traditional IRA Contributions are generally made with after-tax money (similar to the Roth) but may be tax-deductible if you meet income eligibility (check your deduction limits at the IRS website). What does tax-deductible mean? Another Mighty Morphin Powerful question. It means that your IRA contributions can be deducted from your total household income.
Example: If you contribute $6k to a Traditional and your total household income is $100k, you can deduct the $6k contributed and your new household income will be $94k. Add your spouse's contributed $6k to the mix and your total Transforms into Bumblebee, or $88k, whichever you prefer.
Who cares about boring deductions? Well, the benefit of this approach is that it could put you in a lower tax bracket.
Another Example: If you’re floating on clouds in the 22% tax bracket ($40,126 to $85,525) and you’re able to deduct $12k from your total annual income, this could drop you to the 12% tax bracket ($9,876 to $40,125). Paying 12% vs 22% sounds like a Bohemian Rhapsody Grammy winner to me; mamma, you just earned a killer savings.
Earnings grow tax-deferred and are not taxed until you withdraw them after age 59½. Meaning, you do not have to pay taxes on capital gains (your earnings) until you withdraw them. Once you start withdrawing, you’re required to pay taxes on the amount withdrawn corresponding to your tax bracket.
Not really. Anyone 18 or over with earned income can contribute to a Traditional IRA. And similar to a Roth, the contribution limits are $6k per year or $7k if over 50.
Required Minimum Distributions (RMDs)
Oh, and that 3 letter curse word we mentioned from before, Required Minimum Distributions (RMDs), you’ll need to start those at age 72.
Similar to the Roth, if you make withdrawals before 59½, you may have to pay taxes plus an additional 10% tax. There are certain exemptions but it's best to check to see what your specific situation calls for. Check out this article for more info on withdrawals.
With all this tax talk they should write a song about it, matter of fact they did, Taxman by the Beatles, rock on!
The Chicken Wrap on the Traditional
Contribution limit: $6k or $7k
Grows tax deferred
RMDs required at 72
Can NOT withdraw CONTRIBUTIONS penalty free
Contributions may be tax deductible
Great Rich, you told me the difference between the two but now what? How do I know which is best for me? I’m not a Financial Advisor but my 2 cents are free, get it?
Ask yourself if you think your tax rate will be higher or lower in the future? If you can answer that question, you can theoretically choose the type of IRA that will give you the biggest tax savings:
If you expect to be in a higher tax bracket in retirement, choose Roth and its delayed tax benefit.
If you expect lower rates in retirement, choose Traditional and its upfront tax advantage.
If you want more information, ask! We here at Budgets and Brews would be happy to help if we can or point you in the right direction if we can’t.