The Individual Retirement Account (IRA): For Beginners
By: Tanner Yarton
Hello Everyone,
When it comes to savings plans and strategies, they’re a dime a dozen. 401k, 403b, Traditional, and Roth IRA are some notable examples. All of which serve a similar purpose, but which one, or combination of them is right for you?
The Basics:
First things first, let’s introduce our IRA options and their purpose. For the purposes of this article, we will focus here as I believe it will benefit my younger audience the most. In addition to this, I will leave out my personal favorite investments for an IRA, and save that for a later article.
Roth IRA: The Roth IRA is an ‘Individual Retirement Account’, most often used by young people, business owners, and financially savvy individuals. The primary benefit of a Roth is the tax structure. With a Roth IRA, the money contributed ($6000 max deposit FY2022), goes into the account after its been taxed. this means when the account matures at the holder’s age of 59&1/2, the disbursements will be tax free!
Traditional IRA: The Traditional IRA is essentially the opposite of the Roth. Dollars go in untaxed ($6000 max deposit FY2022) and come out at the same age as the Roth, 59&1/2. However, the disbursements at the end are taxed at whatever tax rate is in place at the time.
Benefits:
Both the Roth and the Traditional IRA have a key benefit of being able to invest in *almost* any security. Stocks, bonds, ETFs, as well as foreign and OTC securities. This is a key advantage over, say, a 401k where this type of selective investment is not allowed.
A more finite benefit of the Roth is the assumption that tax rates will generally increase by the time the account is mature, making it a prime option for young adults.
The traditional is more geared towards older individuals as it allows them to increase account size rapidly, assuming in the shorter time until maturity the tax rate changes will be negligible.
Drawbacks:
A key drawback to the IRA options is the inability to withdraw once deposited. The tax benefits are great, but the hinderance to them is a substantial tax on withdrawals before the account is mature.
Additionally, due to the $6000 limit per year the IRA options are not a one stop shop for long term investing. Most individuals couple their IRAs with a second taxable account to put excess disposable income.
Compounding:
For the sake of the conversation, Its important to display the power of compounding returns, which an IRA is perfect for.
Below are some screenshots of a calculator I made to show growth of an account from 20, 30, and 40 years old (until 59&1/2).
20 year old:
30 year old:
40 year old:
These returns are assuming the purchaser is buying VTI 0.00%↑ or SPY 0.00%↑, the market index. I have adjusted the return for inflation as well. For anyone curious, historically the market has returned 10.30% CAGR since inception.
As we can see, there is a significant advantage to starting earlier. Even if the full contribution is not met, The compounding from starting young is tremendous.
Closing notes:
Whether or not you decide to set aside funds for retirement or not, is completely up to you. This article is for educational purposes only and is designed to show a few benefits of making contributions to an IRA.
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Be sure to share with your friends as well!
-Tanner