An IRA, or Individual Retirement Account, is one of several types of retirement account that allow you to make tax-advantaged investments to provide for your financial security when you retire. i.e, it’s a way to save money for retirement. Within the IRA construct, there are two variations: Traditional and Roth. You may have also heard of SEP IRAs and SIMPLE IRAs, but those are not what we are talking about right now – they are Traditional IRAs for specific types of employees.
IRAs have eligibility restrictions that are different from other retirement accounts. Income and employment status can both impact your ability to contribute to an IRA. Additionally, IRAs have contribution limits that are significantly lower than, say, the Thrift Savings Plan or a 401k.
What does “Tax-advantaged” mean?
It means you only pay taxes once! Instead of twice! Woohoo!
With a non-tax-advantaged account, you pay taxes on your income and then again when you sell your investments (because now you have new income). With a tax-advantaged account, you either pay taxes on the earned income or on the investment income – but not both. Dig it.
What is the difference between Traditional and Roth?
Long story very short:
With a Traditional IRA, you contribute to the account with pre-tax money. This means your current year’s taxable income is reduced by how much you contribute to the IRA. Traditional IRAs are also known as “tax-deferred” because you defer paying taxes until you withdraw money from the IRA in retirement.
With a Roth IRA, you contribute with after-tax dollars but your qualified distributions are tax-free, assuming you meet the normal withdrawal criteria.
I’ll be publishing another post soon explaining the differences between Traditional and Roth. For now, just know there are two different tax treatments for IRAs.
What an IRA is not:
An IRA is not a type of investment. It is an account. Within that account, you choose the type of investments you want to put your money in. You can choose from stocks, bonds, mutual funds, etc…even collectibles.
I’ve had people ask me, “what’s the average return for an IRA?”
To put it bluntly, that’s not a thing. There is no such thing as an average return for an IRA. Your return will be based on the types of investments you choose. An IRA just helps you invest in a tax-advantaged way.
How do you open an IRA?
You can open an IRA through a bank, a federally insured credit union, or other financial institutions. It’s not much more difficult than opening a checking account. Here are some basic steps:
- Choose an online broker or other account provider. Make sure you choose one with low fees and good customer service.
- Fill out the information needed to open the account.
- Decide how you will fund your contributions. Personally, I do scheduled monthly transfers from the bank account where my paycheck is deposited.
- Pick your contribution amount. Will you try to max out your IRA at the beginning of the year, or pay a set monthly amount all year long? Both methods have benefits and drawbacks.
- Choose your investments. There are a lot of possibilities here, so make sure the investments you want are available from the company you pick.
- Keep contributing! Build that nest egg!
Eligibility Requirements
To contribute to an IRA, you have to have taxable compensation. For military, compensation includes non-taxable combat pay (score!). You also have to be under the age of 70.5 to open a Traditional IRA. For a Roth IRA, your modified Adjusted Gross Income has to be less than:
- $194,000 for married filing jointly or qualifying widow(er),
- $132,000 for single, head of household, or married filing separately and you did not live with your spouse at any time during the year, and
- $10,000 for married filing separately and you lived with your spouse at any time during the year.
Contribution Limits
Ah, the contribution limits on an IRA. If IRAs have a weak link, I think this is it. Unfortunately, the normal contribution limit for an IRA is $5,500 for 2017. If you are age 50 or older, you can use catch-up contributions to add another $1,000 per year, for a total of $6,500.
Contributions are also limited to your taxable compensation for the year.
Keep in mind that the $5,500 limit is for all IRA accounts, so if you have multiple accounts you need to keep the total contributions below the limit.
Is an IRA Worthwhile?
With such low contribution limits, it may seem like it’s not worth contributing to an IRA. But every little bit helps, and it adds up faster than you think.
I’ve been contributing to an IRA since 2008. At an average contribution limit of $5,250 during that time, I’ll never be able to retire on just an IRA. But, in less than 10 years I’ve been able to save and earn enough to put groceries on the table forever at a 3% withdrawal rate. Or I could use that money to go on a great semi-luxurious two week trip each year. Pretty good for an investment vehicle with a low contribution limit! And that’s just what I have as of today. By the time I retire, I should have significantly more in the account. So, personally, I think an IRA is well worth it if you can fund it.
Anything Else?
Well…yeah. We still haven’t covered withdrawals, or Required Minimum Distributions, or Spousal IRAs, or penalties, or…wow, still a lot to cover. Look for an Intermediate Guide in the future!
What about a traditional IRA vs. a TSP? Is the only difference contribution limits?
There are a few differences, although the difference in contribution limits is a big one.
TSPs can use either Traditional or Roth tax treatments. I’m assuming from your question you are referring to a Traditional TSP, so my answers are geared towards that.
Other than the contribution limits, the major differences are:
1. The TSP is administered by the Federal Retirement Thrift Investment Board. IRAs are administered by a number of financial institutions, so you get to pick who you want to work with.
2. In addition to the higher contribution limits in general with the TSP, military members serving in a Combat Zone Tax Exclusion area get an added benefit of being able to contribute up to $54,000 total (in 2017) through the Annual Addition Limit. This only applies to contributions made to a Traditional TSP, not a Roth TSP. Obviously not everybody will be able to devote that much money to a retirement account in a single year, but the option to contribute that much (almost 10x the IRA limit) is pretty great for people who can swing it.
3. The TSP has a limited number of funds to choose from, while IRAs can have a much greater number of investment options. Neither is really better or worse overall, it just depends on what you prefer. Some people like simplicity and can suffer from analysis paralysis if given too many options, so TSP may be better for them. Others want to do their research and choose the best fit for their situation, so having more options may be a good thing for them.
4. The TSP has a VERY low expense ratio – right now it is about .038%, or $0.38 for every $1,000 invested (average). IRA expense ratios depend on the company and the investments you choose, but generally they are much higher. An IRA with an expense ratio of less than 1%, or $100 per $1,000 invested, is considered low. You can choose a brokerage with an expense ratio of less than .5% ($50/$1,000 invested), but that is still more than 10x the TSP expense ratio.
5. Finally, there are some differences on withdrawals, eligibility, etc but they either only affect a few people, or aren’t concerns until you are much older (I’m assuming you aren’t 60+). The differences I mentioned above are the ones I’d be worried about, if I were choosing between the two.