Author Topic: Am I missing something about IRAs?  (Read 3439 times)

humbleMouse

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Am I missing something about IRAs?
« on: April 22, 2015, 07:45:06 AM »
I am currently 22 years old and have a decent job making about 3k after taxes every month.  I live in a low cost of living area and find myself with extra money every month.

I have read a lot about IRA's and also have read mr money mustache for a while.  From what I can tell, it seems like you cannot withdraw money from an IRA without paying 10% income tax + 10% early withdraw fee.  Am I correct in asserting that you can't withdraw funds without a 20% withdraw fee before age 59?  If this is the case, I find it hard to understand why IRA's are so popular.  In my city (Minneapolis) you can currently buy a condo in any part of the city for under 100k. 

Right now I am debating between putting lots of money in an IRA, or going with some real estate that is going to rise in price as Minneapolis continues to grow.  A 20% fee for taking out my money before age 59 really makes me want to stay clear of IRA's.  Any insight would be appreciated.


Spork

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Re: Am I missing something about IRAs?
« Reply #1 on: April 22, 2015, 07:52:35 AM »
A couple of strategies:
* Most people here are planning on doing a Roth conversion ladder.  There are tons of threads about it, so I won't go into it in detail.  The gist of it is that you can convert some of your traditional IRA every year (post FIRE) and in 5 years that money can be withdrawn without penalty.  You will, of course, have to pay taxes on the conversion.  But that is normally done when you're FIRE'ed and the rate is smaller than it is now.
* Or... you can go the Roth IRA route.  This doesn't reduce your present day tax burden... but it does reduce your future tax burden.  Everything, including earnings comes out of the Roth tax free... and the principal amount can be withdrawn before 59.5 without tax issues.

boarder42

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Re: Am I missing something about IRAs?
« Reply #2 on: April 22, 2015, 07:54:38 AM »
paying a 10% income tax is going to happen now or later.  your realestate will be taxed as well not sure what you're getting at going that route.  also roth ladder

slugline

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Re: Am I missing something about IRAs?
« Reply #3 on: April 22, 2015, 07:55:56 AM »
You're asking about the Traditional IRA, and not a Roth IRA I presume. People like them for the tax-deferral advantage, but you know that already, right?

MMM touches on the topic of how to access your tax-deferred stash before 59-1/2 in this blog post:

http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/

nereo

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Re: Am I missing something about IRAs?
« Reply #4 on: April 22, 2015, 07:56:11 AM »
I have read a lot about IRA's and also have read mr money mustache for a while.  From what I can tell, it seems like you cannot withdraw money from an IRA without paying 10% income tax + 10% early withdraw fee.  Am I correct in asserting that you can't withdraw funds without a 20% withdraw fee before age 59?  If this is the case, I find it hard to understand why IRA's are so popular.  In my city (Minneapolis) you can currently buy a condo in any part of the city for under 100k. 

Right now I am debating between putting lots of money in an IRA, or going with some real estate that is going to rise in price as Minneapolis continues to grow. 
I would say you are 'missing' several things here...

1) IRAs allow you to save money on taxes and then allow that money to grow tax free until you withdraw it.  In the case of a tradiational IRA (t-IRA) you reduce your overall Adjusted Gross Income (AGI) for that tax year.  Say you are in the 20% marginal tax rate and you contribute $5,500 to your IRA.  You will pay $1,100 less in taxes that year (or you will get a refund for $1,100 more.  same difference). 
THEN, that money grows TAX FREE until you withdraw it.  Which means you never pay taxes on capitol gains.  Over time as the balance grows, this can be an incredible savings. 
There's also the ROTH IRA - it also grows tax free, but you don't get the tax deduction when you put the money in. However, when you withdraw the funds, you will never pay taxes on it.  Again, that can be huge, saving you 20% or more.

2) besides the tax advantages (which IMO are the biggest reason) there are ways of accessing that money before you turn 59.5.  Contributions to ROTH-IRAs can be used for a number of things from education expenses to purchasing a home.  There's even a popular strategy of moving money from a t-IRA to a ROTH (aka "Roth IRA Pipeline") that allows people to take advantage of the tax savings immediately and then the tax-free withdraw later in life.

3) purchasing a home is a different question than having retirement savings.  Whether or not you should buy a home is a such a large question that there are dozens of threads on this already, but to put it bluntly, history shows that you are HIGHLY UNLIKELY to get the kinds of returns from your home that you will get from owning an index fund.  On average across all markets, the value of a home keeps up with inflation but doesn't otherwise increase in value.  That's not to say there aren't good reasons to own a home, but for retirement purposes having $200k in a tax-deffered index fund is compeltely different from owning a home valued at $200k.

frugalnacho

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Re: Am I missing something about IRAs?
« Reply #5 on: April 22, 2015, 08:20:14 AM »
I am currently 22 years old and have a decent job making about 3k after taxes every month.  I live in a low cost of living area and find myself with extra money every month.

I have read a lot about IRA's and also have read mr money mustache for a while.  From what I can tell, it seems like you cannot withdraw money from an IRA without paying 10% income tax + 10% early withdraw fee.  Am I correct in asserting that you can't withdraw funds without a 20% withdraw fee before age 59?  If this is the case, I find it hard to understand why IRA's are so popular.  In my city (Minneapolis) you can currently buy a condo in any part of the city for under 100k. 

Right now I am debating between putting lots of money in an IRA, or going with some real estate that is going to rise in price as Minneapolis continues to grow.  A 20% fee for taking out my money before age 59 really makes me want to stay clear of IRA's.  Any insight would be appreciated.

No you are not. 

1. When you put money into an IRA you deduct that amount from your income when you file your taxes at the end of the year.  You do not pay any taxes on the amount you contribute.  Your job is calculating your tax withholding based on how you filled out your w4, so if you didn't plan on contributing to an IRA and account for that when you filled out your w4 then you are likely having too much money withheld and will get a large refund.

2. When you take money out of the IRA it counts as income.  You owe whatever tax you would owe as if you earned that money in the year you withdraw it.  If you are age 60, and have no job all year and earn $0, and decide to withdraw $5,000 from your IRA, you will end up owing no tax because of the standard deduction - it's as if you only earned $5,000 for the year.  If however you have a job and earn $100,000 and still decide to withdraw $5,000, then that $5,000 will just be added to your income so you will end up paying taxes on that money.  Many people on this board are taking advantage of the tax deferred accounts like 401k and IRA to strategically pay the least amount of overall taxes in the long run.

3.  The age to withdraw from the IRA is actually 59 1/2, not 59.   However there are ways to access that money before that age, including "substantially equal periodic payments" via IRS rule 72t, or via the roth pipeline.  I'm sure someone will come in and post links to sources that explain the methods shortly.

Field123

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Re: Am I missing something about IRAs?
« Reply #6 on: April 22, 2015, 08:29:16 AM »
Painfully stupid question, but I will throw it out anyway: My understanding is that in order to qualify for a tax deduction with a Traditional IRA, you must have a MAGI under $70,000, (covered by SIMPLE IRA at work). Is this correct? This being the case, what, if any, advantage would contributing to a Traditional IRA be for someone earning well above $70,000? *Filing status is single

Thanks!

frugalnacho

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Re: Am I missing something about IRAs?
« Reply #7 on: April 22, 2015, 08:38:38 AM »
Painfully stupid question, but I will throw it out anyway: My understanding is that in order to qualify for a tax deduction with a Traditional IRA, you must have a MAGI under $70,000, (covered by SIMPLE IRA at work). Is this correct? This being the case, what, if any, advantage would contributing to a Traditional IRA be for someone earning well above $70,000? *Filing status is single

Thanks!

I'm not sure if that limit is correct.   This has the income limits for traditional IRA deductions if you are covered by a sponsored work plan:  http://www.irs.gov/Retirement-Plans/2015-IRA-Deduction-Limits-Effect-of-Modified-AGI-on-Deduction-if-You-Are-Covered-by-a-Retirement-Plan-at-Work

If you are above the limit for the deduction then you are right, it makes no sense.  You should contribute to a roth IRA at that point.  If you are above the roth deduction limit I believe you can make a non-deductible contribution to your traditional IRA, then roll it over into a roth without paying tax.  I have not done it and am fuzzy on the exact details though.

dandarc

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Re: Am I missing something about IRAs?
« Reply #8 on: April 22, 2015, 08:41:18 AM »

nereo

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Re: Am I missing something about IRAs?
« Reply #9 on: April 22, 2015, 08:53:53 AM »
Painfully stupid question, but I will throw it out anyway: My understanding is that in order to qualify for a tax deduction with a Traditional IRA, you must have a MAGI under $70,000, (covered by SIMPLE IRA at work). Is this correct? This being the case, what, if any, advantage would contributing to a Traditional IRA be for someone earning well above $70,000? *Filing status is single

Thanks!

I'm not sure if that limit is correct.   This has the income limits for traditional IRA deductions if you are covered by a sponsored work plan:  http://www.irs.gov/Retirement-Plans/2015-IRA-Deduction-Limits-Effect-of-Modified-AGI-on-Deduction-if-You-Are-Covered-by-a-Retirement-Plan-at-Work

If you are above the limit for the deduction then you are right, it makes no sense.  You should contribute to a roth IRA at that point.  If you are above the roth deduction limit I believe you can make a non-deductible contribution to your traditional IRA, then roll it over into a roth without paying tax.  I have not done it and am fuzzy on the exact details though.
frugalnacho has the gist of it down, but by investing in an IRA you still get the advantage of having that money grow tax free (e.g. no capitol gains taxes), and you can invest in a ROTH either directly or via rollover, which will then reduce your tax liability upon distribution and allow you access before age 59.5
tax-free growth may not seem important when you only have ~$5k, but as the account grows into 6-figures you can save a bundle each year.

JLee

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Re: Am I missing something about IRAs?
« Reply #10 on: April 22, 2015, 09:32:49 AM »
I am currently 22 years old and have a decent job making about 3k after taxes every month.  I live in a low cost of living area and find myself with extra money every month.

I have read a lot about IRA's and also have read mr money mustache for a while.  From what I can tell, it seems like you cannot withdraw money from an IRA without paying 10% income tax + 10% early withdraw fee.  Am I correct in asserting that you can't withdraw funds without a 20% withdraw fee before age 59?  If this is the case, I find it hard to understand why IRA's are so popular.  In my city (Minneapolis) you can currently buy a condo in any part of the city for under 100k. 

Right now I am debating between putting lots of money in an IRA, or going with some real estate that is going to rise in price as Minneapolis continues to grow.  A 20% fee for taking out my money before age 59 really makes me want to stay clear of IRA's.  Any insight would be appreciated.

Do you have a 401k option through your employer? At $3k take-home, you'd likely be able to defer 25% federal tax by using a traditional 401k/IRA.

neil

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Re: Am I missing something about IRAs?
« Reply #11 on: April 22, 2015, 10:00:34 AM »
During the accumulation (working) phase, you pay taxes based on your earnings, which is somewhat arbitrary based on your career and whatever else you are capable of monetizing.
During the drawdown (retirement) phase, you pay taxes based on your spending.  You would not draw on your IRA more than you need.

Even if I took the 10% hit on purpose, my average tax rate would still be lower than the marginal tax I was saving when I made the contributions.  But as others will mention, there are ways to avoid penalties.

It is true that if your marginal tax rate is 15% or 10%, it might not be as valuable.  However, as you grow a taxable investment account, the tax generated by dividends and interest (and capital gains, if you sell) will drag your returns during your working career.  Ideally, you would probably move into the 25% bracket at some point and those will start being taxed.  After you retire, the tax rate for qualified dividends and capital gains are excellent (if tax law remains as it is now) but you will definitely be starting from a smaller base, no matter how you work out the math.  If you use that to calculate a FIRE date, you can turn this into an estimate of how much the date changes.

Since it is also impossible to estimate changes in the tax law, I like to have a balanced amount of assets, but I also have the luxury of being able to fund everything well.

While having only IRA assets is a doable proposition, Roth IRAs are not as useful in early retirement.  The general "rule" is to use the Roth IRA for low tax brackets, but you might not be able to functionally retire on 72(t) distributions from a Roth, if that is your only option.  The 72(t) approach tends to be low for very early retirement (30s) and is varies significantly depending on the interest rates when you start to elect to take it.  I don't think taking Roth penalties ever makes sense since now you are effectively taxing the money twice.

unmetamorphosed

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Re: Am I missing something about IRAs?
« Reply #12 on: April 22, 2015, 10:09:45 AM »
The definitive post on this topic:

https://seattlecyclone.com/accessing-your-retirement-accounts-early-yes-you-can/

Thanks for this link! Cleared up all my lingering questions.

frugalnacho

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Re: Am I missing something about IRAs?
« Reply #13 on: April 22, 2015, 10:14:01 AM »
During the accumulation (working) phase, you pay taxes based on your earnings, which is somewhat arbitrary based on your career and whatever else you are capable of monetizing.
During the drawdown (retirement) phase, you pay taxes based on your spending.  You would not draw on your IRA more than you need.

Even if I took the 10% hit on purpose, my average tax rate would still be lower than the marginal tax I was saving when I made the contributions.  But as others will mention, there are ways to avoid penalties.

It is true that if your marginal tax rate is 15% or 10%, it might not be as valuable.  However, as you grow a taxable investment account, the tax generated by dividends and interest (and capital gains, if you sell) will drag your returns during your working career.  Ideally, you would probably move into the 25% bracket at some point and those will start being taxed.  After you retire, the tax rate for qualified dividends and capital gains are excellent (if tax law remains as it is now) but you will definitely be starting from a smaller base, no matter how you work out the math.  If you use that to calculate a FIRE date, you can turn this into an estimate of how much the date changes.

Since it is also impossible to estimate changes in the tax law, I like to have a balanced amount of assets, but I also have the luxury of being able to fund everything well.

While having only IRA assets is a doable proposition, Roth IRAs are not as useful in early retirement.  The general "rule" is to use the Roth IRA for low tax brackets, but you might not be able to functionally retire on 72(t) distributions from a Roth, if that is your only option.  The 72(t) approach tends to be low for very early retirement (30s) and is varies significantly depending on the interest rates when you start to elect to take it.  I don't think taking Roth penalties ever makes sense since now you are effectively taxing the money twice.

Why would you need distributions from your roth?  You can withdraw your original contribution (but not gains) from a roth at any time.  It's generally not advisable as you lose that tax free growth potential (if you contribute $5,500 to a roth today, then withdraw it next week, you cannot replace it - your 2015 ira contribution was used up).   This is the whole premise of the roth pipeline (although you do have to wait 5 years for ira rollover contributions to be eligible for withdraw).