Author Topic: Dumb Question About IRAs and their Role  (Read 1962 times)

SouthLand

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Dumb Question About IRAs and their Role
« on: November 06, 2016, 07:46:21 AM »
I'm nervous asking this cause I know it's a stupid question, but after reading through the various literature linked here (MMM, jlcollins, etc.) I still feel like I don't understand, so here's my question:

Outside of employee matches and the tax benefits, what is the role of IRAs in investing for early retirement? Should all my mutual fund investments be pooled in IRA "buckets?"

I have a Roth IRA. I have it independent of my employer, so there's no match. I just put my $5500 a year into it. Is the role of my IRA just the tax benefit? I want to invest a lot more than $5500 a year, so I'm planning to expand my portfolio soon with other, non-IRA funds. Before I do, though, I'm trying to understand what my Roth IRA is even for as an early retirement tool.

Again, I know this is a dumb question, but I'm clearly missing some basic, fundamental understanding of the role of (non-employee matched) IRAs in the FIRE investor's life. If anyone could correct this blind spot in my eye, I'd be very grateful.

MustacheAndaHalf

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Re: Dumb Question About IRAs and their Role
« Reply #1 on: November 06, 2016, 08:24:38 AM »
Technically, "employee matches" do not happen in "IRAs".  You might be thinking of a 401(k) account, which may or may not have an employer match.

The difference between an ordinary account and an IRA is the "tax benefits", so when you remove that difference there isn't anything left.  The rules for IRAs are provided by the IRS, and enforced by the IRS - so it's all about taxes.

More interesting is what to do for early retirement.  Traditional IRAs (anything not a Roth) have a serious flaw - penalties on any early withdrawal.  Roths split the difference: you can withdraw the same dollar amount you put in, but any growth in the account must stay there until age 59.5.  And in this regard, a 401(k) acts like a Traditional IRA and requires waiting.

So what should you use, if you need to retire early?  There's several answers:

1. You could do everything in taxable.  Years ago this was a terrible idea, since interest and dividends are taxable.  But today, the S&P 500 gives off only 2% in dividends, and special tax rates kick in even for that.  Regular accounts ("taxable") could be a reasonable approach when using index funds.

2. Roth IRAs are worth a look.  If you contribute $5,500 a year, and a Roth IRA grows to $8,000 you can still take out the original $5,500.  But the other $2,500 has to remain until age 59.5.  So a partial solution, especially since you should expect to live past 59.5 and wind up using the growth.

3. Traditional IRAs normally would be locked away too long.  But you can do a "Roth conversion" by paying tax.  You can take a $5,000 Traditional IRA, pay tax on $5,000 and get a Roth IRA out of it.  I think there's a 5 year delay after conversion, but then you can again withdraw the $5,000 before the standard retirement age.

Hope that sheds some light on how things work differently for someone aiming for early retirement, but using retirement accounts that assume standard retirement ages.1

seattlecyclone

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Re: Dumb Question About IRAs and their Role
« Reply #2 on: November 06, 2016, 08:30:39 AM »
Is the role of my IRA just the tax benefit?

Basically, yes. Money you put in a Roth IRA will generally never be taxed again, and that can add up to a lot of savings over time! There's nothing at all wrong with investing outside of an IRA, and you should absolutely do this after you fill up your IRA (and workplace retirement account, if available).

SouthLand

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Re: Dumb Question About IRAs and their Role
« Reply #3 on: November 06, 2016, 06:22:47 PM »
Thanks for the feedback! I guess my main concern right now, as I prepare to start making more sustained investments outside of the limited Roth is whether it is more beneficial to devote $5500 a year into the Roth and reap the tax benefits or pool that 5500 in with the rest of my savings into the VTSAX so it can compound with my stock savings and get me a higher return there.

erutio

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Re: Dumb Question About IRAs and their Role
« Reply #4 on: November 06, 2016, 06:28:40 PM »
Thanks for the feedback! I guess my main concern right now, as I prepare to start making more sustained investments outside of the limited Roth is whether it is more beneficial to devote $5500 a year into the Roth and reap the tax benefits or pool that 5500 in with the rest of my savings into the VTSAX so it can compound with my stock savings and get me a higher return there.

You want that first 5500 in VTSAX compounding within the roth IRA, where it will compound tax free forever, whereas any amount compounding in a taxable account will have tax drag on it.

Nothlit

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Re: Dumb Question About IRAs and their Role
« Reply #5 on: November 06, 2016, 07:29:06 PM »
Thanks for the feedback! I guess my main concern right now, as I prepare to start making more sustained investments outside of the limited Roth is whether it is more beneficial to devote $5500 a year into the Roth and reap the tax benefits or pool that 5500 in with the rest of my savings into the VTSAX so it can compound with my stock savings and get me a higher return there.

It sounds like you're thinking that $(A+B) together in a single account will compound faster than $A and $B in separate accounts. This is not the case. :) (Apologies if I misinterpreted your statement.)

SouthLand

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Re: Dumb Question About IRAs and their Role
« Reply #6 on: November 06, 2016, 07:37:55 PM »
Thanks for the feedback! I guess my main concern right now, as I prepare to start making more sustained investments outside of the limited Roth is whether it is more beneficial to devote $5500 a year into the Roth and reap the tax benefits or pool that 5500 in with the rest of my savings into the VTSAX so it can compound with my stock savings and get me a higher return there.

It sounds like you're thinking that $(A+B) together in a single account will compound faster than $A and $B in separate accounts. This is not the case. :) (Apologies if I misinterpreted your statement.)

You did not. That is exactly what I was thinking. My assumption has been that $10,000 in one, compounding account will do better than $5,000 in two identical accounts. I take it my understanding of compound interest could use work? XD

Nothlit

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Re: Dumb Question About IRAs and their Role
« Reply #7 on: November 06, 2016, 08:48:06 PM »
Here's how I proved it to myself. Hopefully I have not made a stupid mistake somewhere in the following math. A typical compound interest formula is usually given as:

A = P*(1+r/n)^(n*t)

Where:
A = future value
P = present value (principal)
r = annual interest rate (e.g., 0.07 for a rate of 7%)
n = number of compounding periods per year (I typically just use n = 1 for simplicity, but it doesn't really matter for this discussion)
t = number of years

If we take all that mess on the right-hand side and just say that C = (1+r/n)^(n*t), we can further simplify this to:
A = P*C

In our scenario, where you have two separate accounts (IRA and taxable), we're assuming you're investing in the same fund (VTSAX) in both, and for the same amount of time. So C would be identical between the two accounts. We'll consider P to be the total principal spread between the two accounts, where P = P1 + P2. At this point the distributive property tells us:

(P1+P2)*C = (P1*C) + (P2*C)

MDM

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Re: Dumb Question About IRAs and their Role
« Reply #8 on: November 06, 2016, 09:04:06 PM »
Here's how I proved it to myself.
Good math!

SouthLand

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Re: Dumb Question About IRAs and their Role
« Reply #9 on: November 06, 2016, 10:42:53 PM »
Gotcha! Thanks for providing the math. That helps me out a lot and makes me feel  a little better going forward from here. :)