Answering: Why Don't We Pay Taxes on IRA Investments?

As April 15th rolls around, tax experts are often asked, "Why don't we pay taxes on IRA investments?" An Individual Retirement Account, or IRA, can be an excellent option for saving. A traditional IRA account is not tax-free, rather it is tax-deferred. Traditional IRA investments defer the payment of capital gains tax until the owner begins to withdraw from the account. In other words when someone opens an IRA, they do not pay taxes on it immediately. They keep reinvesting and letting it grow until they retire. Then, when they withdraw the funds during retirement, they do pay taxes on it. They pay higher taxes because the fund has grown, but are usually in a lower tax bracket because their taxable income is much less after retirement.

Sometimes, when clients ask their tax adviser's, "Why don't we pay taxes on IRA investments?" they are told about the benefits of a Roth IRA. Anyone who is more than ten years away from retirement should consider a Roth IRA. This type of IRA can also be used for investment purposes so long as no cash is withdrawn before retirement age. This type of IRA is usually preferred over the traditional kind, because it frees the purchaser from taxes on the accumulated growth.

There are certain trade-offs with buying and investing in an IRA, so the person who wants to know why we don't pay taxes on IRA investments should be informed about the pitfalls. For instance, the IRS strongly discourages people from cashing in their IRAs until they retire. The traditional age for retirement in America at this time is 62. However, some people wait until they are 70, and some retire as early as 55. If anyone decides to withdraw their funds prior to their retirement, they soon find out that their question, "Why don't we pay taxes on IRA investments?" is moot, because they will very quickly be levied a 10% penalty.

Some people believe that they can only invest in CD's within an IRA. However, there are other choices that have greater reward/risk characteristics. The person who does not have a problem accepting additional risks can invest his or her IRA money in stocks or mutual funds. CD investments are safe, but the returns are lower over the long term. Anyone who considers investing in mutual funds or stocks should be well informed about what he or she is getting into. The investor who is not sure about which way to proceed should ask a financial counselor or tax expert. It is important that the person consulted is honest and has a good reputation. Then, ask, "Why don't' we pay taxes on IRA investments?" or any other tax questions that may come to mind.

Rules and Regulations For a Self-Directed IRA   Why Investing In Silver Is The Way To Go   Borrowing Money From Your 401k   The Rules of a 401k Rollover   Planning Your Retirement Investment   Types of 401(K) Contributions   

Answering the 401k Vs Roth IRA Question

Ever since the Roth IRA was created by Congress as part of the Taxpayer Relief Act of 1997 people have been wondering about the benefits of their 401k vs a Roth IRA. Somehow everyone thinks they need to make a choice between the two, but this is not really the right mindset. As with any other investment diversification is the key and most people should be using both retirement vehicles. As we look closer at the 401k vs Roth IRA debate please keep in mind that this discussion is also applicable to the self directed 401k.

The generally accepted wisdom is to contribute to your 401k up to your employers match and then max out your Roth IRA. If you still have investment dollars after this you can return to your 401k and max that out as well. Many people wonder though if that is the best course of action, especially for those with a self directed 401k who don't have the benefit of an employer match.

Choosing Between a 401k vs a Roth IRA

Keeping in mind that there are rarely any set rules when it comes to your personal finances the choice of 401k vs Roth IRA basically comes down to your current income and tax bracket and what you anticipate your income and tax bracket will be when you retire. This makes it easy to make some generalizations, but since none of us have a crystal ball it is impossible to say with certainty which is a better course.

In general we can assume that a prudent saver and investor will have a higher income when they retire than they do now, especially if we are talking about someone in their 20s or 30s. This suggests the Roth IRA will be the better retirement vehicle. We can also look at current income and deduce that if you are in the 25% or higher tax bracket you will benefit more now from using your 401k to defer taxes. However we have no idea what taxes will do in the future so we cannot say for certain if it is better to have taxable or non-taxable income 20, 30 or 40 years from now.

Diversify and Hedge Your Risk

Since there is no way to determine how tax rates will behave in coming years it makes most sense to diversify and use both retirement vehicles (as well as taxable accounts) to save for your retirement. When you consider how long people are expected to live you may be retired for 30 years or more and taxes can change dramatically even during your retirement. Consider a scenario where taxes are high when you retire, but drop over the coming decades. This means that when you first retire you are better off drawing from a Roth IRA, but as taxes drop you can switch to drawing from your 401k, either partially or fully.

As you can see, it can pay to diversify when considering the 401k vs Roth IRA debate. This applies even for those with a self directed 401k who don't get the benefit of a company match. In the end the question is not so much which retirement vehicle you use, but rather are you saving adequately for your retirement and allowing yourself flexibility in your finances.

Rules and Regulations For a Self-Directed IRA   Why Investing In Silver Is The Way To Go   Borrowing Money From Your 401k   The Rules of a 401k Rollover   Planning Your Retirement Investment