All About IRAs

Add to del.icio.us

IRAs (Individual Retirement Accounts) are a valuable retirement investment vehicle for investors. They allow the investor to avoid paying capital gains and taxes on dividends from their investments. IRAs allow the investor to avoid capital gains taxes on their investments. There are two main types of IRAs: Traditional IRAs and Roth IRAs. Each has its own benefits. This document will describe the differences of these IRAs and provide information about how an IRA account can be most effectively utilized as part of an investor’s overall retirement portfolio strategy.

First, we’ll begin with a summary of the two types of IRAs.

Traditional IRA

The key benefit of a Traditional IRA is that the you gain an immediate tax deduction from your contribution to the IRA. Secondly, money invested in a Traditional IRA will grow without having to make annual tax payments for dividends or realized capital gains. This allows the performance of the account to escape the usual annual tax drag. When money is withdrawn from the account in the future, it is taxed as ordinary income.

Here are some of the key attributes of the Traditional IRA:

  • Traditional IRA contributions can be deducted from federal taxable income.
  • Some states will not allow Traditional IRA contributions to be deducted from income.
  • Contribution limits are constantly changing and are subject to special rules. In 2006, the general contribution limit for young investors was $4,000. Unless the investor is covered by a retirement plan at work, there are no income restrictions for being eligible for participation in a Traditional IRA.
  • Distributions (such as re-invested dividends and realized cap gains) are not taxed while the investment remains in the IRA.
  • Currently, you must start to make withdrawals after you turn 70½ years old. The IRS has rules for the minimum withdrawal that must be made on an annual basis.
  • The withdrawals will be taxed as ordinary income.
  • Early withdrawals: An additional tax of 10% will be applied to all withdrawals made before you have turned 59½ years old.

Roth IRA

The key benefit of a Roth IRA is that you will pay no taxes on money within the account when it is withdrawn. There is no tax deduction for making a contribution to a Roth IRA. Again, money invested in a Roth IRA will grow without having to make annual tax payments for dividends or realized capital gains.

Here are some of the key attributes of the Roth IRA:

  • Roth IRA contributions are not deductible from federal or state taxable income.
  • Contribution limits are constantly changing and are subject to special rules. In 2006, the general contribution limit for young investors was $4,000. An individual who earns more than $110,000 or a household that earns more than $160,000 can not contribute to a Roth IRA. The IRS should be consulted to determine exact rules.
  • Distributions (such as re-invested dividends and realized cap gains) are not taxed while the investment remains in the IRA.
  • For Roth IRAs, there are no required minimum withdrawals when you turn 70 ½ years old.
  • The withdrawals are free from federal tax. In most cases, they are also free from state tax.
  • Early withdrawals: An additional tax of 10% will be applied to all withdrawals made before you have turned 59 ½ years old.

You can invest in both types of IRAs in a single year but your combined contribution must be below the limit for each type (currently $4,000).

Securities to Hold in an IRA

Since the securities in IRAs (both Traditional and Roth) will not create tax liabilities for dividends paid or capital gains realized, you will want to place your most tax inefficient assets into the IRA.

If you have a Roth IRA, you will not be charged capital gains tax on any appreciation of your assets when you eventually withdraw from the account. Thus, you should also consider the expected rate of return of the asset when determining whether it should be held in a Roth IRA account. An asset with a high expected rate of return would be a good candidate since you believe that the capital gains tax due on this asset will be a large amount in the future. You should do the calculation to determine whether it makes sense to hold an asset with a high rate of return (but small annual tax drag from taxes on realized capital gains and dividends) in your Roth IRA.

If you have a Traditional IRA, then you should focus on assets that generate larger annual tax liabilities from dividends and realized capital gains. These tax liabilities produce a direct reduction in the net rate of growth of the asset.

You should remain careful about moving highly appreciating assets into a Traditional IRA since the money will eventually be taxed as ordinary income. If you expect your future ordinary income tax rate to be high then you should weigh the pros and cons of moving an asset with a high expected rate of return into the IRA. While you will be spared paying taxes on the annual distributions and realized capital gains, the tax paid upon withdrawal from the IRA may be substantial.

From the standpoint of annual taxes on distributions and capital gains, some of the most tax inefficient asset classes are: Treasuries, REITs, and Small Value funds. Please refer to our Tax Sheltered Accounts page for more information.

Comparison of IRAs

Now, we’ll show a quick comparison of how the different IRAs compare given the same investment and time horizon. We’ll compare three possible investment options: the Traditional IRA, the Roth IRA and a non-IRA investment account. Let’s assume that $1,000 is the initial investment and the time horizon is 20 years. We will use a pre-tax rate of return of 8% for the investment vehicle and a post-tax rate of return of 7%. This drag of 1% is probably slightly conservative based on the tax losses suffered by Treasuries and REITs. Since the Traditional IRA creates an initial tax deduction, we will take the amount of tax savings and invest that in a taxable account for the duration of the analysis. At the conclusion of the 20 years, we will take out the appropriate taxes (ordinary income and capital gains taxes).

For tax rates, we assume a relatively high tax burden — 25% federal and 10% state income tax and 15% federal and 10% state capital gains. These would be consistent with having moderate to high income and living in a higher tax state such as New York or California.

Here are the results of our sample investment in the three vehicles.

Table 1: Comparison of IRAs
Traditional IRA Roth IRA Taxable Account
Initial Contribution $1,000 $1,000 $1,000
Initial Tax Savings $350 - -
Effective Rate of Growth 8%, 7% 8% 7%
Pre-tax final value of initial contribution $10,063 $10,063 $7,612
Pre-tax final value of tax savings $2,664 - -
Post-tax final value $8,626 $10,063 $5,959

Note: In the Traditional IRA, there is a 7% growth rate for the tax savings portion of the initial investment.

We see that the Roth IRA account creates the greatest final position. The Roth has two major advantages. First, its contribution grows at a higher rate of return since there is no annual tax drag on realized capital gains or dividends. Secondly, there is no tax on the final position. The Traditional IRA has the advantage of creating an initial tax savings. However, the savings from the initial tax deduction will grow at an annual rate of 7% since they are not in a tax-free account and capital gains taxes must be paid on this amount at the end of the 20 years. Additionally, the ordinary income taxes must be paid on the final value of the contributions in the Traditional IRA. The combination of the slower rate of growth and tax payments results in a lower overall position for the Traditional IRA. The Non-IRA investment performs the worst. The reasons are clear: no initial tax savings, slower rate of growth and the requirement to pay capital gains tax on the final position. This account under-performs the Roth IRA by approximately 40%. That is a big difference!

We are also assuming that the individual has the ability to invest the money saved by the Traditional IRA’s tax deduction. If the investor is limited by his funds available (and those levels are less than the contribution limits), then the Traditional and Roth IRAs will lead to equivalent outcomes. In that case, assume that the investor has $1000 available in pre-tax money to invest and has an income tax rate of 30%. If he went with a Traditional IRA, he could invest the full $1000. However, if he used a Roth IRA, he would have $700 in post-tax dollars available to invest. Thus, the Traditional IRA would just start with a higher contribution (because of the benefit of the tax deduction) but that advantage would be eliminated at the end of the period when taxes are applied to the Traditional IRA but not the Roth.

The Roth IRA seems to be the preferred vehicle for investors (if they are eligible). If not, you should definitely make investments in a Traditional IRA for retirement savings. The Roth IRA will not be advantageous over the Traditional IRA when the amount contributed is under the limit for the IRAs – they will both have the same effectiveness.

Using our method of conducting this analysis, the performance of the Traditional IRA would improve if the income tax rate were lower. That points out one of the important considerations that you should make when deciding on the best plan. You must estimate the future tax rate that you will face when you are retired and making withdrawals from the IRA. If you expect your tax rate to increase, the Roth IRA will look better. However, if you are currently in a high tax bracket and expect to be paying taxes at a much lower rate in the future, then the Traditional IRA becomes more appealing.

There are many calculators available on the internet that allow performance comparison based on your personal situation and beliefs. See the Resources section at the end of this document for some links.

Converting a Traditional IRA to a Roth

If you meet certain income criteria, you may be eligible to transfer funds from a Traditional IRA account into a Roth IRA account. The funds will be immediately taxed as ordinary income but will be tax free for the remainder of the investment horizon. This can be a particularly strong move if your current ordinary tax rate would be low in the year of conversion. It makes even more sense if you will be able to pay the taxes on the converted amount without draining the IRA. Remember the Roth IRA does include the added flexibility that the investor will not be required to make withdrawals when he reaches the age of 70½.

Note that Congress recently passed a law that the income restrictions for being eligible to make a conversion to a Roth IRA will be repealed in 2010.

Resources

Moneychimp – The Moneychimp.com website gives a good overview of the advantages of the Roth IRA. It includes several calculators as well.

Rothira.com – This website is dedicated to Roth IRA information.

IRS – The Publication 590 by the IRS explores all the rules of Traditional and Roth IRAs in detail. These rules are being changed every year so this is a good resource to review.