The Individual Retirement Account - Understanding an Investment Vehicle for Financial Wealth
Don’t you wish you had a pension plan? If you did, you might not have to worry about this Individual Retirement Accounting thing. But if you are like the rest of us, you need to know what an Individual Retirement Account is, more specifically, a Traditional Individual Retirement Account…aka Traditional IRA
What is a Traditional IRA?
A Traditional IRA is a retirement account that is specifically designed for retirement savings. The cool thing is money goes into this account using pre-taxed dollars. It’s like you didn’t pay any income taxes on the money that went into the Traditional IRA.
This “pre-taxed” money goes into this account and show grow until you reach retirement. When you reach retirement, you can take money out of this account, but since you didn’t pay any taxes on it before, it is now subject to ordinary tax rates.
This is important because you’re getting to defer taxes at the beginning, but at the end ALL of your Traditional IRA is taxed at ordinary (principle and the increase in value).
Why is that important, well, because in our current tax law, if you just put your money in a regular brokerage account and bought and sold stocks (after holding the security for longer than 1 year), you could potentially pay a lower tax rate. This doesn’t happen with a Traditional IRA.
Why should you be considering a Traditional IRA?
First of all, you should open a Traditional IRA if your income limits you the ability to open a Roth IRA account. (Personally, I prefer a Roth IRA first). Due to the income limits, you might not be able to open a Roth IRA and therefore the only other option is a Traditional IRA.
Secondly, if you don’t have a retirement plan period, then something is better than nothing. I’d rather you open a Traditional IRA than not opening any retirement account.
Third, you believe that when you retire, you will be in a lower tax bracket. By deferring taxes NOW, you effectively are betting that in the future (when you retire) the tax rate will be lower. There is valid arguments that this could happen, especially if you are in a high tax bracket now. The idea is that when you retire, you don’t need as much money as you do now, so you need a higher income now (thereby in a higher tax bracket) and lower bracket later.
If you haven’t checked out my reasoning for opening a Roth IRA and why I think that’s a better bet, check out that blog here.
Fourth, you really need to save taxes now, rather than later. I get it, an extra $1,000 of tax savings now can make a big difference to a family (understanding that they are giving up $5,000 in retirement savings). So by saving taxes now, you see the financial benefits today.
How to open a Traditional IRA account?
Opening a Traditional IRA is simple. All you need is a brokerage firm that offers a Traditional IRA. You can open a Traditional IRA at a bank, but they may only offer savings accounts and a 1 or 2% return is not what you are looking for in the long run.
If you don’t have a lot of money to start with, check out Fidelity or Schwab. If you have at least $3,000, check out Vanguard. Either way, make sure you choose a diversified balanced portfolio of investments that have low fee index funds.