What is an IRA?
An IRA or IRA account is a Individual Retirement Account that allows people to make annual contributions which can than be invested into stocks, bonds, mutual funds, etc and continues to grow under a tax deferred status.
The primary functions of an IRA are:
- Provide individuals who don’t have an employer sponsored retirement plan such as a 401k, an investment tool to help save for retirement.
- Provide a tax deferred account in which no capital gains or dividend income is taxed until it is withdrawn.
To understand the implications of how amazing a tax deferred retirement account can be, we need to look at the different types of IRA’s.
What’s the Difference Between a Roth Ira and a Traditional IRA?
With a Traditional IRA, the amount you contribute to your account is deducted from your taxable income in the year you make your contribution.
Let’s say Mike made $40,000 in 2016. Mike is 25 years old and made the maximum contribution of $5,500 to his traditional IRA. When Mike goes to file his federal income tax return he gets to deduct the full $5,500 from his taxable income. Therefore (excluding other deductions) Mikes original $40,000 is only taxed as if it were $34,500.
According to the IRS income tax calculator which you can find here. The difference this makes is quite significant:
- If mikes full $40,000 was taxed he would have paid $3,978 in taxes.
- With the $5,500 deduction Mikes taxable income is only $34,500 and he would have paid $3,152 in taxes.
Mike just saved $826 he would have otherwise paid to the IRS and put away $5,500 for retirement!
With a Roth IRA, you don’t get to deduct your annual contribution from your taxable income, instead the earnings you make from your investments within the Roth IRA account and the amount you withdraw from the account simply isn’t taxed.
Let’s say Mike contributes the current maximum IRA contribution limit for his age of $5,500 annually to a Roth IRA account. When mike reaches the IRA retirement age of (59 1/2) he can simply withdraw the money he contributed over the years without having to pay capital gains tax on his earnings, or income tax on the amounts withdrawn.
For example, if Mike (age 25) invests his $5,500 into the Vanguard Total Stock Market Index Fund (VTSAX) and earned the market average return of 7% every year he would earn $385.
Assuming Mike is still in the 15% (long term) capital gains tax bracket at the IRA retirement age he would be able to defer the 15% capital gains tax on the $385 he made or $57.75 keeping the full amount.
When you factor in an annual contribution of $5,500 and compounding interest over 34 1/2 years (from age 25 to 59 1/2) that’s some serious tax savings!
In addition to not paying capital gains tax on a Roth IRA, Mike wouldn’t have to pay income tax on any of the amount’s he withdrew from the account either. That’s huge!