For some unknown reason, the vast majority of working adults seem to think that Individual Retirement Arrangements (IRAs) are the gold standard of financial planning. So beloved are IRAs that virtually everyone you talk to either has one or plans to open one as soon as possible. What is it about them that makes them so popular? Have banks and brokers done such a good job of marketing that they’ve made everyone forget about the many disadvantages of this otherwise mundane form of investing? Is the much-touted tax deduction really that good of a deal?
Here’s a quick, and objective, look at the good and bad aspects of IRAs:
The Many Advantages
Most working adults who have IRAs can parrot the key selling points, and they are good ones: they allow you to deduct the contribution amount on your taxes, up to a certain limit of course. This feature has the potential to lower your tax bill immediately. Then, after you retire and begin to withdraw the money, you will presumably be in a lower bracket when you pay tax on the withdrawals.
Often overlooked, even among the pro-IRA crowd, is the fact that any interest paid on the account during its existence is allowed to grow, tax-free, until you take the funds out. For investors who start contributing early in their working life, this is a massive advantage because of the power of compounding interest. Finally, the IRS gives you a little wiggle room by allowing you to contribute past the end of the calendar year, up to April 15. That means you can wait until April of 2020, for example, to make your 2019 IRA contribution.
One thing seldom mentioned in IRA articles online is the fact that investors have to be able to predict the future to make them work. In other words, there’s really no way you can know what the tax situation will be when you retire. If you’re in your twenties, for example, your retirement years might be tax-free, or Congress might pass laws banning IRAs ten years from now. Who knows what the tax environment will be like five decades from now?
Two other big downsides are the rules about required distributions. You’ll have to take them after you turn 70 whether you want them or not, and you’ll have to pay at least some tax on them. If you forget to take the distribution, the IRS levies a hefty penalty on you, depending how long you waited past the limit and how much money you should have taken out. It’s a taxation rule-book nightmare of sorts, and lots of investors would just rather not take part.
Can You Have Both?
The ideal situation is having access to a 401k where you work and also setting up your own. That’s a good way to take advantage of any matching contributions by your employer and having the option to invest in just about anything you want within the IRA. Most 401k, plans, by the way, don’t allow for much flexibility. Their big selling point is the higher contribution limit and employer matching.