A traditional IRA is an individual retirement account that you open and control yourself rather than through an employer. If you qualify to deduct your contribution, you receive a tax break in the year you contribute, the money grows tax-protected, and withdrawals get taxed as ordinary income in retirement. That can be particularly valuable if you contribute during peak earning years and withdraw the money later at a lower tax rate. IRAs also offer meaningful asset protection from creditors. Contributions generally require earned income, although a nonworking spouse could contribute to their own IRA based on the working spouse’s income through what is commonly called a spousal IRA.
High earners with a workplace retirement plan may not be eligible to deduct traditional IRA contributions, which makes a nondeductible traditional IRA less attractive on its own. However, it can serve as the first step in the Backdoor Roth IRA process. A high earner can make a nondeductible contribution to a traditional IRA and then convert that money to a Roth IRA, where future growth and qualified withdrawals can be tax-free. The process is relatively straightforward but needs to be done correctly. In particular, investors need to understand the pro rata rule if they have existing money in traditional, SEP, or SIMPLE IRAs and properly report the transaction on Form 8606.
Traditional IRA money is intended for retirement, and withdrawals before age 59 1/2 generally come with income taxes plus a 10% penalty. However, numerous exceptions exist to the early withdrawal penalty, including certain withdrawals related to disability, domestic abuse, and a first-home purchase. Early retirees can also access IRA money using Substantially Equal Periodic Payments (SEPP) under Rule 72(t), provided they follow the requirements for the withdrawals. The bigger mistake is often avoiding an IRA because of concerns about accessing the money early and investing in a taxable brokerage account instead. When IRA space is available for retirement savings, taking advantage of its tax-protected growth and asset protection is generally preferable to unnecessarily investing those dollars in a taxable account.
When it comes to saving for retirement, you've probably heard the term IRA. This stands for an individual retirement arrangement, and the beautiful thing about this is that first word is individual, meaning it's specific to you. You don't share one with your spouse. It doesn't have to come from an employer. You can open it anytime you want, anywhere you want, and you can control what's in there and when the money comes out of it. You're in the driver's seat. That's what people like about IRAs.
It is a type of retirement account, and because the government wants you to save for retirement, it gives you some tax breaks associated with those accounts. When it comes to a traditional IRA, some people are able to actually deduct the amount they put in there from their income each year. And so if you put $5,000 in there and your marginal tax rate were, you know, 40%, well, you would get a $2,000 tax deduction for putting $5,000 into that account, and you still have all the money in the account. So it's a beautiful thing.
And then it grows for 10 years, 20 years, 50 years, whatever, in a tax-protected way. So it grows without any tax drag that you would have in your taxable, non-qualified brokerage account. It grows faster because it's in there. Plus, most states protect it from creditors, and even the federal government has some protection from creditors for that money. So, in the event that you had some terrible above-policy-limits judgment and you had to declare bankruptcy, you actually get to keep what's in your IRA, which is a pretty cool benefit. And so, I think they're great places to save, especially if you're saving for retirement.
So, the way a traditional IRA works is you get the tax break up front. It grows in a tax-protected way, and when it comes out on the back end, you have to pay taxes at your ordinary income tax rates. But typically in retirement, most people are in a lower tax bracket than they were during their peak earnings years, and so there's also this arbitrage between your tax rate now and your tax rate later. And so that can be another really great tax advantage of investing in a traditional IRA.
One of the requirements of investing in these is you have to have earned income, or at least your spouse has to have earned income in an amount sufficient to justify the contribution. You can't contribute more than you earn, and so this is not for somebody who just wants to move some unlimited amount of money in there. This is not for somebody who's not working to use. A general retiree cannot make contributions to a traditional IRA. You can't put money in there for your kids, right? It has to be earned income that goes in there, but it can be earned by your spouse. That's often called a spousal IRA. It's not a separate type of IRA. It's just somebody else's traditional IRA that happens to be your spouse, and the contribution can be justified from your earnings.
You've probably heard of Roth IRAs. These are a little bit different from traditional IRAs. Instead of getting the, instead of paying taxes at the end when you take the money out of the account, you pay taxes at the beginning when you put the money into the account, and then it grows tax-free. And when the money comes out in retirement, it comes out completely tax-free.
And deciding between those two, if they're both available to you, is one of the hardest things to do in personal finance and investing. So, if it seems really complicated, know that you're not alone and that it's a hard decision. Sometimes it's obvious, but oftentimes it isn't. Console yourself with the fact that if it isn't obvious which one you should use, it probably doesn't matter all that much which one you do use.
Keep in mind, for high earners who have a retirement plan available to them at work, like a 401(k) or a 403(b), they often cannot deduct their contributions to a traditional IRA. They still grow in a tax-protected way, and when the money comes out on the backside, the contribution amount comes out tax-free, but all the earnings are still taxable.
That's not nearly as good a deal as if you got a deduction up front for it, but in some situations might still be worth it. Just recognize that that is a different animal.
But what a lot of high earners do because of that, and because they're also not allowed to contribute directly to a Roth IRA, is they do what's called a backdoor Roth IRA, and they contribute to a Roth IRA, but they do it indirectly. They first put money into a traditional IRA. This is money they earn. They don't get a tax deduction for it because they earn too much and they have a plan available to them at work. And then the next day they convert that traditional IRA money to a Roth IRA. They move it from the traditional IRA to the Roth IRA. Because they never got a tax break on putting the money in, there's no tax cost to convert it. And now not only does that principal come out tax-free when you withdraw it in retirement, but all of the earnings do as well.
That's called the backdoor Roth IRA process, and you can look on the White Coat Investor website. We have a very extensive tutorial to walk you through that process.
One of the things that people worry about with a traditional IRA is the age 59 1/2 rule. And this is a rule that says basically, if you pull money out of your IRAs before age 59 1/2, you have to pay any taxes due, and you have to pay a 10% penalty. And so, in general, this is money designed for retirement. It's designed for money that you're going to be spending in your 60s and 70s and 80s and 90s, and it's best to just leave it in there until then. You can pull it out and pay that penalty, but generally you want to avoid doing so.
What nobody tells you very often, though, is there are all kinds of exceptions that let you pull that money out before age 59 1/2, such as death or disability or even domestic abuse. There are all kinds of these reasons that you can take money out. Buying a first home is one of them. Your money can come out penalty-free as well. It doesn't even have to be your first home. It can be your kid's first home.
And one of the exceptions that people don't realize is early retirement. This is often called the substantially equal periodic payment rule, or the 72(t) rule. But basically, as long as you take withdrawals for at least five years and at least until you turn 59 1/2, you can take an equal amount of money out each year penalty-free from your IRA.
So just because you want to retire early is not a reason to not use retirement accounts or a traditional IRA. You should still use it. You can still get your money penalty-free before age 59 1/2.
So mistakes that people make with traditional IRAs, well, the main one is just not using it. Right? They're investing in a taxable account when they could be investing in an IRA and having their money grow faster in an asset-protected way. That's a mistake.
Likewise, they may be thinking they get a deduction for contributing to a traditional IRA and not realizing till the end of the year that they do not. Or maybe they know about the backdoor Roth IRA process but don't complete it correctly. Right? They get messed up by what's called the pro rata rule because they still have some money in a traditional or SEP or SIMPLE IRA at the end of the year they did the conversion step of that backdoor Roth IRA process on, or they fill out the tax form, Form 8606, wrong.
These are ways in which you create some problems with your backdoor Roth IRA each year, but for the most part, these rules are not that complicated. You can work with them, and your money grows faster, and it's asset-protected. So when you can save more money in an IRA, whether a traditional IRA or a Roth IRA, you should do so. It is definitely preferable to investing in a regular old brokerage, taxable, non-qualified account.
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The White Coat Investor Podcast is for your entertainment and information only and should not be considered financial, legal, tax, or investment advice. Investing involves risk, including the possible loss of principal. You should consult the appropriate professional for specific advice relating to your situation.
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