Author Topic: Really new, questions about IRAs  (Read 6961 times)

pfvnoobie

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Really new, questions about IRAs
« on: August 19, 2014, 03:01:26 PM »
So I'm a 23 year old dude who is very new to the idea of investing, but I'm hoping to retire sometime between 40 and 45 years old.. I have no debt, and have about $10,000 I'm looking to invest. I was looking at opening an account at Vanguard, when I got stumped on what type of account I should be opening.

I see many people say that you should use a Roth IRA so you don't have to pay taxes on your gains, but this seems counter-intuitive to me since you can't pull your money out until you're around 60 years old. Why should I not just invest using a taxable account?

Also, how much worse would the result of investing in a taxable account be compared to an IRA over the course of 20 years?

Thanks for any responses!

seattlecyclone

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Re: Really new, questions about IRAs
« Reply #1 on: August 19, 2014, 03:26:13 PM »
I see many people say that you should use a Roth IRA so you don't have to pay taxes on your gains, but this seems counter-intuitive to me since you can't pull your money out until you're around 60 years old. Why should I not just invest using a taxable account?

First of all, you can pull your money out of a Roth IRA before you turn 60. The contributions can be withdrawn penalty free. Any gains can also be withdrawn if necessary, but you will pay tax penalties on it so it should only be done as an absolute last resort.

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Also, how much worse would the result of investing in a taxable account be compared to an IRA over the course of 20 years?

Let's suppose you invested $10k in VINIX (Vanguard's S&P 500 Index Fund for institutional investors) on August 19th, 1994. The price at that time was $44.21/share. The current share price is $181.20, making your investment worth $40,986, more than quadrupling in value. If you sold after 20 years, you would pay long-term capital gains tax on the gain, which could be equivalent to 15% of $30,986, or $4,647 that you would pay in taxes when selling out of the taxable account. By comparison, the Roth IRA has no taxation.

This is ignoring the effect of dividends. The fund pays out dividends every quarter. In a taxable account you will owe tax on each and every dividend payment before you can reinvest it. In the Roth IRA, no taxes are owed. So the real effect of the Roth IRA is actually much bigger than the $4,647 that you would save if dividends didn't exist.

RyeWhiskey

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Re: Really new, questions about IRAs
« Reply #2 on: August 19, 2014, 03:31:05 PM »
Use a search engine to learn about the differences between IRAs. It's really quite simple, in a nutshell:

IRA: Money goes in "pre-tax," grows tax free, has required minimum withdrawals which are taxed at tax rate at time of withdrawal.

Roth IRA: Money goes in "post-tax," grows tax free, has no required minimum withdrawals, principle can be withdrawn at any time for various stated reasons.

Taxable: Money goes in "post-tax," all dividends and capital gains are taxed at according tax rate.

It's easy to see how the tax-shelter saves money in the long run due to compounding and lack of taxes thereupon. The only situation where this is not the case is if you're in a low enough tax bracket that your qualified dividends and capital gains are taxed at 0%. Even so, that situation could change, so it's always a good idea to have as much tax-sheltered space as possible, especially if you want to hold bonds or REITs or something which is not as tax-friendly as broad market equity indexes.

somecobwebs

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Re: Really new, questions about IRAs
« Reply #3 on: August 19, 2014, 03:38:55 PM »
Came here to ask essentially this exact question. (I am in a similar situation, and similarly new to this.) Thank you all for your clarifying posts!

For a Roth IRA, do you also get dividends, or just from mutual funds? In what ways does having a Roth IRA support early retirement exactly? Is it just a good place for emergency cash, or does it actually generate money?

I'm also having a bit of trouble understanding what exactly changes after having the account open for 5 years. I have been googling, but I feel like I'm still missing some big concept.

So sorry for all of these incredibly n00b questions. (Some background: I am self-employed and don't make very much money, so I am in a low tax bracket, and I don't have a 401K.)

seattlecyclone

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Re: Really new, questions about IRAs
« Reply #4 on: August 19, 2014, 04:30:45 PM »
For a Roth IRA, do you also get dividends, or just from mutual funds? In what ways does having a Roth IRA support early retirement exactly? Is it just a good place for emergency cash, or does it actually generate money?

Think of an IRA like a magical tax-free shield that you can put around a limited portion of your investments. You can wrap mutual funds with this IRA shield. Same goes for individual stocks, bonds, FDIC insured savings, or even rental real estate! If an investment pays dividends in a taxable account, it will pay those same dividends in your IRA. The difference is that you don't have to pay tax on the dividends when they're paid to your IRA.

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I'm also having a bit of trouble understanding what exactly changes after having the account open for 5 years. I have been googling, but I feel like I'm still missing some big concept.

There are two different five-year rules for a Roth IRA. This post does a decent job of explaining them.

In a nutshell, the first rule says that your Roth IRA earnings are only tax-free if you have had a Roth IRA for at least five years when you take your first qualified distribution. So if you start your Roth at age 59 and withdraw your earnings from it at 60, you'll have to pay taxes on the gains, but if you wait until age 64, the gains are tax-free.

The second five-year rule is probably discussed more often here as part of a "Roth pipeline" strategy. This rule says that Roth conversions (from a Traditional IRA or 401(k)) may be withdrawn penalty-free after five years. This is a common strategy whereby an early retiree would make a traditional->Roth conversion for the living expenses they plan to have five years down the road. After five years, they withdraw the converted amount penalty-free. Search for the "Roth pipeline" for more details about this strategy if you're interested. If you're just starting out, you might want to learn some other stuff first because you can't really put the Roth pipeline into action until five years before you intend to retire.

pfvnoobie

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Re: Really new, questions about IRAs
« Reply #5 on: August 19, 2014, 04:58:39 PM »
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First of all, you can pull your money out of a Roth IRA before you turn 60. The contributions can be withdrawn penalty free. Any gains can also be withdrawn if necessary, but you will pay tax penalties on it so it should only be done as an absolute last resort.

I'm assuming you're talking about this 72(t) (Roth pipeline, as seattlecyclone talks about) thing I've seen some people mention. From what I understand though, it has a 5 year lead time, so you have to be pretty certain of what you're doing, and can be difficult to do. Also, is there a chance laws could change making this option unavailable in the future?

You said the contributions can be withdrawn penalty free from a Roth IRA... Does this mean that if I put $10,000 in myself over 10 years, and it earned $1,000 of interest, that I could pull up to $10,000 out before age 60, but would have to wait to withdraw any further? In that case, do early retiree's just try to get their contributions high enough that at a 4% SWR, they don't withdraw more than they've already contributed before they turn 60? I hope this question makes sense.

Eric

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Re: Really new, questions about IRAs
« Reply #6 on: August 19, 2014, 05:26:11 PM »
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First of all, you can pull your money out of a Roth IRA before you turn 60. The contributions can be withdrawn penalty free. Any gains can also be withdrawn if necessary, but you will pay tax penalties on it so it should only be done as an absolute last resort.

I'm assuming you're talking about this 72(t) (Roth pipeline, as seattlecyclone talks about) thing I've seen some people mention. From what I understand though, it has a 5 year lead time, so you have to be pretty certain of what you're doing, and can be difficult to do. Also, is there a chance laws could change making this option unavailable in the future?

No.  The Roth Pipeline is a method to get Traditional IRA funds into a Roth IRA account, thereby gaining access prior to age 59.5.  If your funds originated in a Roth IRA account, there is no 5 year lead time.  You can deposit $5500 today and withdrawal it all tomorrow with no penalties.  As stated above, this applies to contributions only.  So if you deposit $5500 and it grows to $6000 next year, you can still only withdrawal $5500 penalty free.  The earnings above your contributions can be withdrawn penalty free but only after 59.5.  Earnings withdrawn prior to 59.5 will incur a penalty.

You said the contributions can be withdrawn penalty free from a Roth IRA... Does this mean that if I put $10,000 in myself over 10 years, and it earned $1,000 of interest, that I could pull up to $10,000 out before age 60, but would have to wait to withdraw any further? In that case, do early retiree's just try to get their contributions high enough that at a 4% SWR, they don't withdraw more than they've already contributed before they turn 60? I hope this question makes sense.
This is correct, that you'd be able to withdrawal the $10,000 prior to age 59.5 in this scenario.  Roth IRAs have a current contribution limit of $5500/yr, so you're going to end up with investments in your 401k/403b if you have one and/or taxable accounts in in addition to the Roth.  You'd have to live an extremely spartan existence to be able to fund a retirement solely using a Roth IRA.

So early retirees will have a mix of accounts from which to withdrawal from, which is actually beneficial as it allows a lot of flexibility when it comes to taxes and income.
« Last Edit: August 19, 2014, 05:28:01 PM by Eric »

pfvnoobie

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Re: Really new, questions about IRAs
« Reply #7 on: August 19, 2014, 05:55:35 PM »
Quote
Quote
Quote from: pfvnoobie on Today at 04:58:39 PM
You said the contributions can be withdrawn penalty free from a Roth IRA... Does this mean that if I put $10,000 in myself over 10 years, and it earned $1,000 of interest, that I could pull up to $10,000 out before age 60, but would have to wait to withdraw any further? In that case, do early retiree's just try to get their contributions high enough that at a 4% SWR, they don't withdraw more than they've already contributed before they turn 60? I hope this question makes sense.
This is correct, that you'd be able to withdrawal the $10,000 prior to age 59.5 in this scenario.  Roth IRAs have a current contribution limit of $5500/yr, so you're going to end up with investments in your 401k/403b if you have one and/or taxable accounts in in addition to the Roth.  You'd have to live an extremely spartan existence to be able to fund a retirement solely using a Roth IRA.

So early retirees will have a mix of accounts from which to withdrawal from, which is actually beneficial as it allows a lot of flexibility when it comes to taxes and income.

So really, there's no reason to not use a Roth IRA for early retirement, except that I won't be able to access the interest gained tax-free until I'm 59.9?

Eric

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Re: Really new, questions about IRAs
« Reply #8 on: August 19, 2014, 06:29:56 PM »
So really, there's no reason to not use a Roth IRA for early retirement, except that I won't be able to access the interest gained tax-free until I'm 59.9?

In general, yes, Roths are great.  Not to confuse you too much, but there could be a reason to forgo the Roth IRA, because your IRA contributions are capped at $5500/yr, so you could decide to contribute to a Traditional IRA instead.  (It'd be nice if you could do $5500 to each, but unfortunately that's not how it works.)  That would allow you to save on taxes now instead of later.  And in general, most people are in a higher tax bracket when working than in retirement.  But tIRAs have less flexibility as you're not supposed to be able to access any of the contributions or earnings until age 59.5.  (And that's where converting it to a Roth (aka Roth Pipeline) comes in)

So there's a tradeoff between flexibility and tax savings.  I think most posters around here prefer the Roth even at the reduced tax savings.  However, the Mad Fientist argues the opposite.  (And he's a pretty sharp guy).  So it's kind of a personal preference type of thing based on your own personal situation.  The closer your retirement income is to your working income, the more favorable the Roth becomes, and the bigger the income gap the more favorable the Traditional IRA becomes.  But of course you're not locked in to one or the other.  You could contribute to a tIRA one year, and a Roth IRA the next, or some combination of both in the same year up to $5500 combined.

http://www.madfientist.com/traditional-ira-vs-roth-ira/

pfvnoobie

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Re: Really new, questions about IRAs
« Reply #9 on: August 19, 2014, 07:30:56 PM »
Awesome. You guys have all been really helpful, and I think I have a much better idea of how things work now. So far I'm liking the MMM forums :D

I'm now planning on investing 5500 into a Roth IRA through vanguard, and the rest into a taxable account.

Anything else I might need to know before I do this?

somecobwebs

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Re: Really new, questions about IRAs
« Reply #10 on: August 19, 2014, 10:29:08 PM »
Thank you everyone! I feel like I have a much stronger grasp now. And thanks also to pfvnoobie for posting this question :)

Aphalite

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Re: Really new, questions about IRAs
« Reply #11 on: August 20, 2014, 08:46:52 AM »
Awesome. You guys have all been really helpful, and I think I have a much better idea of how things work now. So far I'm liking the MMM forums :D

I'm now planning on investing 5500 into a Roth IRA through vanguard, and the rest into a taxable account.

Anything else I might need to know before I do this?

Do you have access to a 401k/403b at your work? Or have the ability to open a solo 401k because your income is from self employment?

If so, you should max those before any sort of IRA, otherwise, Roth IRA then Taxable is fine

RyeWhiskey

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Re: Really new, questions about IRAs
« Reply #12 on: August 20, 2014, 11:01:31 AM »
^ aphalite is correct.

Generally speaking the method of funding accounts is:
401k up to company match first, then HSA, then Roth IRA or regular IRA (depending upon tax situation), then taxable.

usmarine1975

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Re: Really new, questions about IRAs
« Reply #13 on: August 20, 2014, 11:20:16 AM »
Not to muddy the water but as a self employed individual you could look into a SEP or a Simple IRA.  I can't speak to your exact circumstances but something to look into.

http://www.irs.gov/publications/p560/ch02.html

One thing to note is if you hire employee's you will also have to contribute for them as well.

Gives you a way to stash more then $5500/yr

dragoncar

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Re: Really new, questions about IRAs
« Reply #14 on: August 20, 2014, 11:52:37 AM »
I see many people say that you should use a Roth IRA so you don't have to pay taxes on your gains, but this seems counter-intuitive to me since you can't pull your money out until you're around 60 years old. Why should I not just invest using a taxable account?

First of all, you can pull your money out of a Roth IRA before you turn 60. The contributions can be withdrawn penalty free. Any gains can also be withdrawn if necessary, but you will pay tax penalties on it so it should only be done as an absolute last resort.

Quote
Also, how much worse would the result of investing in a taxable account be compared to an IRA over the course of 20 years?

Let's suppose you invested $10k in VINIX (Vanguard's S&P 500 Index Fund for institutional investors) on August 19th, 1994. The price at that time was $44.21/share. The current share price is $181.20, making your investment worth $40,986, more than quadrupling in value. If you sold after 20 years, you would pay long-term capital gains tax on the gain, which could be equivalent to 15% of $30,986, or $4,647 that you would pay in taxes when selling out of the taxable account. By comparison, the Roth IRA has no taxation.

This is ignoring the effect of dividends. The fund pays out dividends every quarter. In a taxable account you will owe tax on each and every dividend payment before you can reinvest it. In the Roth IRA, no taxes are owed. So the real effect of the Roth IRA is actually much bigger than the $4,647 that you would save if dividends didn't exist.

This also assumes you never sell, which, lets be honest, is probably not true.  You might rebalance a few times.  Or your fund's expense ratio could go up and you decide to switch funds.  This is no problem in a Roth, but creates taxable events in taxable.

Iron Mike Sharpe

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Cwadda

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Re: Really new, questions about IRAs
« Reply #16 on: August 20, 2014, 01:35:12 PM »
Awesome. You guys have all been really helpful, and I think I have a much better idea of how things work now. So far I'm liking the MMM forums :D

I'm now planning on investing 5500 into a Roth IRA through vanguard, and the rest into a taxable account.

Anything else I might need to know before I do this?

You could put in $5500 for 2014 and then in Decemberish put another $5500 in for 2015.

For Vanguard, hitting the $10k will reduce your expense ratios further.

Eric

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Re: Really new, questions about IRAs
« Reply #17 on: August 20, 2014, 01:51:50 PM »
Awesome. You guys have all been really helpful, and I think I have a much better idea of how things work now. So far I'm liking the MMM forums :D

I'm now planning on investing 5500 into a Roth IRA through vanguard, and the rest into a taxable account.

Anything else I might need to know before I do this?

You could put in $5500 for 2014 and then in Decemberish put another $5500 in for 2015.

For Vanguard, hitting the $10k will reduce your expense ratios further.

I don't think it works that way.  You can contribute to your 2014 IRA from 1/1/14 to 4/15/15 (tax day), but you can't contribute to your 2015 IRA until 1/1/15.

Cwadda

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Re: Really new, questions about IRAs
« Reply #18 on: August 20, 2014, 01:55:34 PM »
You're probably right on that. Although I did submit my contribution request in mid December and specified it be allocated to 2015. They set it up for me.

pfvnoobie

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Re: Really new, questions about IRAs
« Reply #19 on: August 22, 2014, 12:47:46 AM »
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I don't think it works that way.  You can contribute to your 2014 IRA from 1/1/14 to 4/15/15 (tax day), but you can't contribute to your 2015 IRA until 1/1/15.
Good to know

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Do you have access to a 401k/403b at your work? Or have the ability to open a solo 401k because your income is from self employment? If so, you should max those before any sort of IRA, otherwise, Roth IRA then Taxable is fine
Already maxing 401k to the extent that my employer matches. Not self-employed


Thanks though for another round of ideas guys!

BooksAreNerdy

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Re: Really new, questions about IRAs
« Reply #20 on: August 22, 2014, 09:14:34 AM »
A lot of people here recommend maxing out the 401k to IRS limits of 17500, if you can. Definitely do that before using taxable accounts. Ideally, you fund 401k to company match, open a Roth IRA, then if you still have money left, fill up the 401k.

Also look into HSA if your insurance offers one.

THEN you can look into taxable accts.

curiousnomad

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Re: Really new, questions about IRAs
« Reply #21 on: August 24, 2014, 12:28:12 AM »
My 401k appears to have a roth option. So now I'm really confused.

I opened a roth ira before I realized the 401k had a roth option. My company match is only 3% (I've already contributed past that for 2014 in the trad401k). Plus I still have student loans ranging from 2-7%. I have aprox 2k/mo (variable weekly pay) to throw at all these - please tell me which order to do them!

Or should I try to write a case study request with actual numbers?

Aphalite

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Re: Really new, questions about IRAs
« Reply #22 on: August 25, 2014, 07:26:21 AM »
My suggestion on order to do these:

1) Get company match using traditional 401k (if it's an annual amount and you've already met it, fine, if they match on a paycheck basis, you need to do at least 3% each pay period)
2) Pay off any debt over 5% <-- arbitrary number but 5% is the minimum guaranteed return I would take
3) contribute to 401k until you hit max ($17.5k)
4) Contribute to separate Roth IRA option outside of your 401k ($5.5k)

Sounds like you might have enough to do all of these. Debt under 5% is not that bad. Most people carry around that on their mortgage. If your loans are public, you might be able to refinance into a lower rate with SoFi or a similar company

teen persuasion

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Re: Really new, questions about IRAs
« Reply #23 on: August 25, 2014, 09:04:54 AM »
My 401k appears to have a roth option. So now I'm really confused.

I opened a roth ira before I realized the 401k had a roth option. My company match is only 3% (I've already contributed past that for 2014 in the trad401k). Plus I still have student loans ranging from 2-7%. I have aprox 2k/mo (variable weekly pay) to throw at all these - please tell me which order to do them!

Or should I try to write a case study request with actual numbers?

You have to crunch the numbers to see what effect pre-tax 401k vs Roth 401k contributions would have.  If your income is high enough, all pre-tax might be best, for the tax savings.  If your income is lower, there would be no point contributing to pre-tax past the point of zero income tax; the remainder should go in Roth accounts.  E.g., DH contributes the max to his traditional 401k (no Roth option), and our taxable income reaches zero.  I contribute $5500 to Roth IRAs for each of us, since there is no more tax advantage to traditional IRAs for us.  It is complicated, because many things can influence your taxes - children, itemize vs standard deduction, EITC, CTC, retirement savers credit, student loan interest deduction, etc.