How do individual plans work?

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Do you like doing taxes? Do you like paying taxes? Normally you have to fill out the paperwork and pay taxes for every investment asset you sell. But good news: the federal government wants you to save for retirement and provides strong incentives for you to do so. Retirement accounts not only help you prepare for retirement, but also save you time and money when it comes to taxes.

Individual Retirement Accounts (IRAs), in contrast to 401(k)s, are generally self-funded.  You can open one with any brokerage firm (such as e*trade or Fidelity) or by consulting an investment manager.  For 2012, you can deposit up to $5,000 per year in your IRA (not to exceed your earned income).  You can begin withdrawing money without penalty at 59 ½.  For information on penalties and exceptions, visit this IRS page.   You can invest the cash in your IRAs in any funds, stocks, or bonds that you choose.  And when you realize gains, you do not have to report them for tax purposes in the year you earned the money.

There are two basic kinds of IRA: the traditional IRA and the Roth IRA.  A traditional IRA receives similar tax-preferred treatment as a traditional 401(k): depending on your adjusted gross income, contributions are deducted from your income and untaxed, and you pay ordinary income tax (but no capital gains tax) on your qualified distributions.  Distributions become mandatory at 70 ½.  A Roth IRA receives the opposite income tax treatment: you pay ordinary income tax on contributions in the year the money is earned, but when taking qualified distributions, you pay no tax at all.  Either way, you legally dodge capital gains tax.  If you are selling and buying (“realizing gains”) instead of just holding one asset continually, this means that you get to invest an extra 15% (the 2012 capital gains rate) of your profit because you didn’t have to pay taxes on it.   This extra investment means more of your money is working for you.  Over decades, this difference can amount to an enormous advantage. 

Legally avoiding taxes is well and good; but how do you know which type of IRA to choose?  For starters, you can have both.  The question is which to contribute to in a given year.  If you think your marginal tax rate will be higher at the time you’re making your contribution, you should contribute to your traditional IRA; if you think your rate will be higher when you’re taking distributions in retirement, you should contribute to your Roth IRA.

  roth IRA Traditional IRA
Contribution Limits $5,000 $5,000
Catch-Up (Over age 50) $1,000 $1,000
Contribution Phaseouts Yes No
Contribution Age Limit None 70 and 1/2
Deduction Phaseouts NA Yes
Minimum Distribution Only after death During life and death
Early withdrawal exceptions unique to IRA accounts
  • Higher education
  • First time home purchase (up to $10K)
  • To pay health insurance premiums when unemployed
Tax on Qualified Withdrawals No tax Taxed as ordinary income

tax on non-qualified withdrawals

Depends on the balance of the adjusted basis

Pay tax and penalty on entire withdrawal amount

You can read more about IRAs here.