Three Secrets (Almost) Nobody Wants You To Know About IRAs

Scrabble tiles are arranged to spell "IRA" on a tile rack, with additional tiles scattered on a wooden surface.

I was having a friendly conversation with a professional acquaintance recently and happened to mention that I had just finished contributing to my IRA for this year. “Really?” she replied. “My accountant told me I couldn’t contribute to an IRA.”

I was shocked that any accountant would make such a statement, because virtually anybody can contribute to an IRA (aka Individual Retirement Arrangement) if s/he has earned income for the year. But then I realized what we were dealing with here was monumental failure to communicate. What the accountant had (hopefully) meant to say was that my acquaintance couldn’t get a tax deduction for her IRA contribution, which was indeed probably the case. Yet too frequently the two messages are conflated, and they are not at all the same thing.

This got me to thinking that clients also routinely ask me why I recommend that they contribute to an IRA when their tax guy tells them not to do it. Thereupon typically ensues a useful conversation, which I would like to share with you here.

A Difference Of Perspective

I have a lot of respect for all of the tax guys in the world. They know a lot, do a tough job, and operate under a lot of pressure. I sure as heck wouldn’t want to do without my own. That said, it’s useful to remember that most tax professionals see the world through a very specific lens. Most are paid to do one and only one job: minimize the taxes a client owes on the tax year just recently concluded. In other words, their attention is focused tightly on the immediate past. And the question that guides their enterprise is “Will this lower my client’s tax bill?”

If that is your focus and your goal, then it is logical that one “shouldn’t” contribute to an IRA if one can’t claim a tax deduction for doing so. That is, however, usually the wrong answer.

It’s “wrong” because most people have bigger and more important goals than simply minimizing their most recent year’s tax bill. They also have long-term goals: to achieve career success, to meet personal and family goals, and to accumulate enough wealth achieve financial security. And even if they don’t get an immediate tax deduction for it, contributing to an IRA can help achieve these broader goals.

Secret #1: You CAN Contribute

So don’t be intimidated. As long as you have earned income you CAN contribute to an IRA. Indeed, even if you don’t work but are married to someone who earns enough to cover two contributions, you can contribute. The rules regarding the deductibility of a contribution are indeed complicated, but now you are among the elite who know that that is a different question entirely.

Even if you have access to a 401(k) or 403(b) at work, you can contribute to an IRA.

Don’t forget: investment income and passive income aren’t eligible. It has to be earned income.

Secret #2: Your Investment Gains Are Shielded

We’re thinking long term here, remember. Once your long-term savings are in an IRA, investment gains are shielded from current taxation. That can be a very big deal for dual income couples and high-income singles who are taxed at particularly high rates during their peak earning years. California, for example, taxes all capital gains as regular income anyway, so if you live in the Golden State keeping as much as possible out of the current reach of the Tax Man makes sense.

Also remember: if you earn more than $250,000 (i.e., if you belong to almost any two-income professional household in Silicon Valley) your investment earnings are subject to an additional 3.8% Obamacare tax. Investment earnings in IRAs, of course, are shielded.

Secret #3: You Can Make Tax-Efficient Roth IRA Conversions

You may make too much money to contribute directly to a Roth IRA, but that doesn’t mean that you can’t convert some or all of your IRA savings to Roth IRA savings. Any such conversion, of course, is subject to current taxation. But after-tax contributions to IRAs, though ‘subject to taxation,’ won’t actually be taxed again if converted to Roth savings. That results in tax-efficient Roth conversions at least, and tax-free Roth conversions if all of your conversion consists of after-tax funds.

Over time, making after-tax IRA contributions and then doing tax-efficient Roth conversions can result in very substantial Roth savings. That’s tax-free forever, for those of you who have forgotten.

Bonus Secret: IRAs Can Help In Other Ways As Well

Keeping as much of your savings in the “retirement savings” category as possible – including IRAs and Roth IRAs – can help in other ways as well. Retirement savings are generally considered unavailable for college expenses when your child applies for financial aid. IRAs are also afforded greater protections from creditors than regular savings (though not as much as “qualified” plans like 401(k)s). And then there’s the fact that you will be less tempted to raid your savings to splurge on that trip to Tahiti – at least until you’re retired.

So, go ahead and contribute to your IRA, this year and every year, for as long as you can. Your future self will thank you.


21 December 2015

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