As physicians, sometimes it can feel like you’re constantly paying taxes. For as hard as you work, this can definitely be a drag. Luckily, when it comes to your retirement accounts, there is a way to grow your retirement money tax free, allowing you to keep a significant amount of your gains over the years.
Under current law, the government allows individuals to place their money into an account that grants their investments the ability to grow tax deferred or tax free depending on which account is set up. These accounts are called Individual Retirement Accounts, commonly referred to as an IRA.
What Is An IRA?
An IRA is an investment account that acts primarily as a savings account with tax breaks. The IRA itself is not an investment; it is simply an account that allows you to hold investments (stocks, bonds and mutual funds) that will grow tax deferred or tax free.
You read that right; all income earned from dividends, interest and capital gains will be allowed to grow and compound each year without having taxes be taken out of it. This makes it an ideal way to save for your retirement and grow your hard earned money over time.
Why Do You Need An IRA?
In additional to the amazing ability to grow your investments tax deferred or tax free, there are a few other reasons to open up an IRA. Many employers offer a sponsored plan to help their employees retire called a 401k. These plans, while great, have some downsides to them.
While we won’t get into all the detail here, opening up an IRA will allow you to supplement your earnings in your 401k during retirement. An IRA will also give you access to a much wider range of investment products that will still able to keep the deferral or tax free growth on your money.
Lastly, it will grant you the flexibility to take a tax deduction in the year that money was contributed or allow you to withdraw any funds at retirement tax free.
Traditional Vs Roth IRA
There are two main types of IRA accounts: Traditional IRA accounts and Roth IRA accounts. While both accounts allow your investments to grow tax free from now up until you retire, they have some major differences that you should be aware of.
1. Differences in IRA Contributions
Contributions are the amount of cash that you put into the plan each year. There are restrictions on how much can be put into these plans each year. As of 2016, both Traditional and Roth IRA’s have a maximum contribution amount of $5,500 or $6,500 if you are over age 50.
The way the contributions are treated, from a tax perspective, is different in a Traditional IRA vs. a Roth IRA. For example, in a Traditional IRA, the contributions that you make are able to be deducted on your tax return. The income on investments will still grow tax free, but the tax is just deferred until the funds are withdrawn in retirement.
In a Roth IRA, the contributions you make are with after tax money. You are not eligible to receive tax deductions in the current year for any contribution made, but grow and can be distributed tax free.
2. Differences in IRA Distributions
In a traditional IRA, you must start withdrawing a portion of their money by the time you reach age 70 ½. The government has allowed you to grow your money tax free until you retired, even allowing you to not claim it as income in the year it was contributed (the current year tax deduction). By the time you are age 70 ½, the government requires you to make a distribution each year so they can start to earn tax revenue on the income you have earned over all the years (this is called a requirement minimum distribution or RMD).
In contrast, a Roth IRA has no required distribution. This is due to the fact that you have already been taxed on that money (when it was contributed by using after tax dollars) and now those funds were allowed to grow tax free. You can leave the money in the IRA for as long as you want, and it can still grow tax free up until death.
While a Roth IRA seems like the obvious choice for those looking to open up an IRA, there are income requirements that might prohibit you from starting a Roth IRA. Individuals that make more than $129,000 ($191,000 for married couples) are not eligible to start a Roth IRA, but can still start a traditional IRA. There are ways to get all of your traditional IRA funds into a Roth IRA, called a Backdoor IRA, but I will save that for another more detailed post.
In conclusion, I want to emphasize that Uncle Sam can change these rules at any time. What is in place today might not be the same when you retire.
Regardless of which IRA plan you choose, make sure you take the initial step and actually open one up! Remember, every source of income, whether it’s tax free or not, is important in retirement. The goal is to supplement your 401k and add to your retirement nest egg so you can achieve financial freedom quicker and retire when you want.