IRAs-Back to Basics Series
Truthfully, most physicians have about zero use for a traditional individual retirement arrangement (IRA). In residency, they should be doing Roth IRAs and later in their career, they make too much money to deduct their traditional IRA contributions. But it is still worthwhile understanding how a traditional IRA works as it is the basis for understanding other, more useful types of retirement accounts, such as backdoor Roth IRAs, converted IRAs, rollover IRAs, 401Ks, SEP-IRAs, stretch IRAs etc.
A traditional IRA allows you to contribute up to $5000 a year of earned income for you and another $5000 for a non-working spouse. After age 50, you can make an additional $1000 “catch-up” contribution each. If you are covered by an employer’s retirement plan, such as a 401K, you can only deduct these contributions if your income is under $66,000 (single) or $110,000 (married.) That disqualifies most physicians and those who aren’t disqualified should probably be using a Roth IRA. If you aren’t covered by an employer’s plan, there are retirement plans out there (such as a solo 401K or SEP-IRA) that allow for much larger contributions which should probably be used if at all possible.
The money in a traditional IRA grows tax-free. If you withdraw the money prior to age 59 1/2, you will have to pay an additional 10% tax as well as any income tax which would be owed on the money. After that age, you just have to pay the income tax. Once you hit age 70, you are required to start withdrawing part of the money each year, the “Required Minimum Distribution (RMD).” This is age based and starts out at about 3.6% and increases to about 8.8% at age 90. That is one benefit of Roth IRAs over traditional IRAs-Roth IRAs have no RMDs.
Traditional IRAs can be opened at just about any bank, brokerage firm, or mutual fund company. You can invest in most publicly traded securities including stocks, bonds, mutual funds, or CDs. There are even ways you can make private investments, including real estate, in an IRA. You cannot invest on margin in an IRA. You cannot take a loan from an IRA (unlike a 401K). An IRA is generally protected from creditors. Contributions for any given year must be made between January 1st of that year and April 15th of the next year.
It is important to understand the difference between accounts (taxable, traditional IRA, 401K) and investments (stock, bond, CD, or mutual fund). Consider accounts as types of luggage and investments as types of clothes. You may need a different type of luggage for a different type of trip. But you can just as easily put a t-shirt inside a backpack as a suitcase or a carry-on. You can also put an investment inside many different types of investment accounts.
The traditional IRA is the basic framework for all retirement accounts. A solid understanding of how it works will allow you to understand all your other retirement accounts. You can get more details from IRS Pub 590.