Thriving Millionaires

By Eric

Note: This post is Part One of a three-part series. You can find the other parts here:

Part Two: In Defense of the Traditional IRA

Part Three: In Defense of the Roth IRA

The Individual Retirement Account, or IRA, came into existence in 1974 when companies were beginning to move away from Defined Benefit Plans (think pension) to Defined Contribution Plans (think 401ks/403bs and the like). The creation of IRAs was a part of the Employee Retirement Income Security Act when the US Government began to put new options in place to help individuals save for retirement to help ensure bright futures during the twilight years.

A few years after its creation, IRAs received a substantial change in structure – allowing non-working spouses to also contribute to an IRA in 1977, although at a significantly lower rate ($250). While the IRA was in existence for years before becoming popular, the thing that really moved the IRA into the common conversation relative to personal finance was when the contribution limit was increased from the $1,500 it had been since its inception to $2,000 in 1982.

In 1998, non-working spouses were allowed to contribute at the same rate as a working spouse (at the time, still $2,000) and the limit was raised for both working and non-working spouses in 2002 to $3,000. 2002 was also the first year that “catch-up” contributions were permittable for workers over the age of 50 (a $500 limit at the time).

The current (2019) limits are $6,000 per person (working and non-working) with an additional $1,000 limit for people over the age of 50. While IRA contribution limits are lower than current contribution limits on other retirement accounts such as 401ks and 403bs, IRAs still can serve an important role in your retirement savings plan.

Generally speaking, most employer-sponsored retirement plans such as 401ks have a set list of available investment options. This means that your employer and your employer’s plan provider provide a list of available investments for you to select from – but this list may not cover every type of investment or fund you would want to invest in.

For me, I have only 10 investment options to choose from in my employer-sponsored 401k: 7 stock and 3 bond. Of those stock funds, 1 is the company stock and only 1 is internationally focused. Of the bond funds, one has such a high expense ratio, I can’t reasonably invest money in it and be able to sleep at night. While this mix works for some (and I certainly still take advantage of the 401k benefits), I would prefer to have more options – especially with lower expense ratios!

However, IRAs give you the ability to access a much wider array of investment options. Whether you’re looking for stocks, bonds, mutual funds, ETFs, domestic or international – you can find the right mix of investment options through most IRA providers. Because of this broader mix of investment options, you also have the ability to look at options with different expense ratios.

If your 401k plan offers a mutual fund that invests in large-cap US stocks with an expense ratio of 1.0%, you may be able to find a similar investment vehicle in the nearly unlimited options an IRA provides with an expense ratio of only 0.15%. When you talk fractions of a single percent, it’s easy to over-simplify and not pay attention to the fees. However, if you carry this example forward through time, the impact is very pronounced.

For example, if you invest $5,000 per year and achieve a 7% return per year, at the end of 30 years, the difference between a 1.0% fee and a 0.15% fee is nearly $65,000. Said differently, you could achieve the same balance in year 28 with the lower expense ratio as you would in 30 years with the higher expense ratio. When you are talking about retirement accounts, which IRAs are, thinking about the impact of fractions of a percent over an entire career becomes important.

Because this is only the first part of our three-part series on IRAs (Part Two, Part Three – links coming soon!), I won’t spent much time debating the pros and cons of Traditional IRAs vs Roth IRAs, but I do want to provide a top-level summary of each.

Traditional IRAs act similarly to most 401ks. The money is contributed to the IRA pre-tax which allows you to reduce your taxable income in the year(s) you contribute to the IRA. When you reach retirement and begin withdrawing the funds, you pay income tax in whatever is your current tax bracket on the principle and the earnings. Traditional IRAs also require minimum distributions once you turn 70 ½ per IRS regulations.

Funding a Roth IRA is done with after-tax dollars, which means you pay taxes in your current tax bracket (in the year(s) you contribute to the IRA) – but because you have already paid tax on the principle, the withdrawals in retirement are tax-free. Roth IRAs do not require minimum distributions unlike Traditional IRAs. However, there are income limits to Roth IRAs that may come into play depending on your level of income.

In both Traditional and Roth IRAs, early withdrawals (before age 59 ½) are included in that year’s gross income (meaning it is included in your taxable base) as well as a 10% penalty. This makes early IRA withdrawals very costly unless you fall into one of the exceptions for early withdrawals. Below is a quick list of situations in which you can withdraw from your IRA early without the 10% penalty (Note – the below is not an exhaustive or complete list. There are additional restrictions that may apply, we advise you to visit the IRS website and/or consult a tax professional):

• If you become disabled
• To pay for non-reimbursed medical expenses
• If you are a first-time home buyer
• Higher education expenses
• Paying back-taxes to the IRS
• To pay for medical insurance
• If you pass away

All in all, IRAs can serve an important role in your personal finance planning. They provide additional and different benefits that can complement a 401k or other employer-sponsored retirement account. Most personal finance professionals agree that IRAs are an excellent way to save money for retirement – the debate generally focuses around Traditional vs Roth, which is why we are making this a three-part series. You can find the links to Parts Two and Three below:

Part Two: In Defense of the Traditional IRA

Part Three: In Defense of the Roth IRA

Patrick’s Thoughts:

In a prior post titled, “Planning Without Goals is Folly,” I referenced a young professional putting all his savings in a Roth-IRA. A couple years later, this individual was looking to purchase an engagement ring but didn’t have the cash to purchase it. I couldn’t help but think of this example when reading Eric’s comments above. There is no arguing the fact that IRAs can, and usually should, be an important part of your retirement savings. What I’d like to do today is pull out a few of the key points Eric makes above as you begin thinking about your savings strategy:

“This makes early IRA withdrawals very costly unless you fall into one of the exceptions for early withdrawals.”

While there are exceptions to being able to withdraw money early, I personally think there are better ways to plan for a situation where that would be needed. Many 401K plans offer the option to borrow against your account. If you’re in a tight situation, it might make sense to take a short-term (1 year) loan against your 401k. Receiving a loan is not a taxable event unless the loan limits and repayment rules are violated. It has no impact on your credit rating which is another benefit. This might be a simpler option than pulling money out of your IRA, because you will be forced to pay that money back over the period. As a side benefit, the interest-paid is paid back to your account. It’s also could be a financially better option than taking a traditional loan from a bank.

With that being said, the key consideration here is that as you plan for your retirement savings strategy, you will want to have a mix of investment vehicles that allow you to flex money when those situations come up. If you’re all-in on IRA accounts, you might find yourself in an unfortunate pickle you don’t want to be in.

“The difference between a 1% fee and a 0.15% fee is nearly $65,000.”

This is a critical point that would be very easy to overlook. While 1% doesn’t seem like an incredibly large fee, as Eric points out above, even 1% can add up to a significant amount over time. It’s easy to go with what’s easy and invest in the options given to you by your employer. While this may simplify your life, it can cost you a significant amount in the long run.

IRAs aside, it’s important that you are evaluating the costs of any investment or financial advisory service you are using. Take the time to understand each plan, and invest in one that you think will provide the best overall value. The reason I say “overall value” is because there is nothing wrong with paying a higher-fee if you feel it will be worth it. For example, a friend of mine had a financial adviser who was able to save him hundreds of thousands of dollars by understanding certain rules and tax advantages of his government-sponsored pension. If he didn’t have someone with that level of expertise advising him, he could have missed out on a serious opportunity to maintain his government pension and collect social security.

“In 1998, non-working spouses were allowed to contribute at the same rate as working spouses.”

This is an important benefit that should not be overlooked. Approximately a third of families with a working parent depend on only one-income. This can make a sound savings strategy even more important because money can be tighter and you’re not receiving additional retirement contributions from two different incomes.

Don’t assume that just because you’ve hit your contribution limit, that an investment vehicle is no longer available to you. With the relatively low contribution caps for IRAs this is a wonderful benefit for families with only one-income.

All-in-all, I think Eric did a great job introducing IRAs, and I am looking forward to further dialogue as we begin to debate some of the different options out there!

Note: This post is Part One of a three-part series. You can find the other parts here:

Part Two: In Defense of the Traditional IRA

Part Three: In Defense of the Roth IRA