In this week's financials edition of Industry Focus, Gaby Lapera talks with special guest Dan Caplinger about how investors can get the most out of their IRAs. Listen in to find out the difference between a Roth IRA and a traditional IRA (and which type is right for you), why you might want to convert between them and how you could go about doing that, how many IRAs you can have at one time, how beneficiaries work with IRAs versus wills, and more.
A full transcript follows the video.
This podcast was recorded on Jun. 6, 2016.
Gaby Lapera: Hello everyone, welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You are listening to the financials edition, filmed today on June 6th, 2016. Today's episode is a primer on individual retirement accounts. My name is Gaby Lapera and joining me on Skype to talk about IRAs is Dan Caplinger, chief of our personal finance and investment planning bureau. Thanks for joining me. How's it going, Dan?
Dan Caplinger: I'm doing good, Gaby. Thanks for having me on again.
Lapera: I'm really excited to have you here. I'm sure our listeners will be, too. Just so you guys know, we're going to cover a fair amount of material today. Heads up for our listeners -- we'll be talking about what an IRA is, why you need one, the different types of IRAs, how to pick one, why you'd want to convert an IRA, how to do it, and then a blurb on 401(k)s. Now, you can use your little 15-second skip button to get to the part that you're interested in, but I hope you listen to it all anyway, because Dan and I are both fascinating creatures. (laughs)
Let's start with this. IRA stands for individual retirement accounts, and everyone should have one. Right, Dan?
Lapera: Since everyone should have one, can everyone have one?
Caplinger: Well, no, actually. In order to have an IRA -- whichever type you're talking about, either a traditional IRA or a Roth IRA -- the one thing you have to have is earned income. That means money that you get from a job or from a business that you run yourself. You can't set up an IRA for your three year-old kid. You can't contribute to an IRA if you've retired and you don't get any money from a job. But in between, the sky is pretty much the limit as far as being able to get that IRA set up for you.
Lapera: In terms of jobs, would that include baby sitting money? Or is it something that you need to have a tax return for?
Caplinger: No. It includes anything that you do work in order to earn money. Baby sitting, lawn work, anything like that is fair game. It's not unheard of for parents to set up IRAs for their kids based on that money that they earn, whether it's chores around the house or an outside business like a lawn care or baby sitting. That's fair game and the IRS is totally fine with you setting up an IRA based on it.
Lapera: Yeah. And I know we probably sound a little bit like a broken record here at the Fool, but it is really important to start saving as early as possible for retirement. If your kid is doing some kind of business at 12 or 15 or however old they are -- although, you should check your state's labor laws to make sure that they're legal to be working -- you should maybe think about setting up an IRA for them.
Caplinger: It's a huge gift that really keeps on giving. Every extra five years' head start that you get makes such a huge difference. Even if it's a small amount of money that you're talking about, the power of compounding, if you can find an investment that provides a solid return year in and year out, getting an extra 5, 10, 15 years under your belt by starting earlier than you otherwise would, that makes a huge amount of difference and really reduces the future burden of being able to save enough to get to where you want to be financially.
Lapera: People might be wondering if they, for whatever reason, have never heard of an IRA -- what's a difference between an IRA and a regular savings account? Why would you want an IRA versus just keeping your money in the bank?
Caplinger: The biggest advantage that an IRA has is it's tax-deferred, which means that as your investments earn income over the years, you don't have to pay tax on it. If you keep money in a regular savings account, in a regular brokerage account, you're going to have to pay taxes on the interest, on the dividends, on the capital gains when you sell. You're going to have to do that over time.
But with an IRA, you don't have to do that. Even if you generate income, you don't have to pay tax on it in the current year. Even if you sell something at a profit, you don't have to pay capital gains tax in that year. And really, the only trade-off there is, once money goes into the retirement account, it's a little bit more difficult to get it out before retirement.
The idea here is really to give yourselves a long-term savings vehicle to let that power of tax deferral work to your advantage over the course of your career, and make the most of that tax break that the IRS is willing to give you.
Lapera: Right. I just want to stress that this isn't some kind of loophole that were telling you about. The government did this on purpose. They want you to save for your retirement, especially in an era where pensions are not a common thing anymore. That's why you get all these tax advantages on this account.
Caplinger: Exactly right.
Lapera: Now that we know what an IRA is and who can get one, are there different types of IRAs that we should be aware about?
Caplinger: There are. There are a couple of different kinds of IRAs that are the most common that you're going to run into. One is called the traditional, the other is called the Roth. The traditional has been around for a lot longer, and it's the IRA that more people are most familiar with. With the traditional IRA, you put money into the account. Most people will get an immediate tax break in the form of a deduction for how much they put in. If they put in $1,000 into their traditional IRA, they'll get a $1,000 write-off for their taxable income. That will generate some tax savings right away.
The Roth IRA is a little bit different. With a Roth IRA, you don't get an up-front deduction for the amount that you contribute. But, unlike a traditional IRA, you get a big tax break down the line. With a Roth IRA, when you take money out of it in retirement, it's tax-free. With a traditional IRA, you have to pay taxes on those deferrals that you've been getting the benefit of for all those years and decades. At the end of a traditional IRA, the IRS decides they're going to get their share in the form of taxes. But with a Roth IRA, you don't have that. So the question becomes, what's more valuable to you? That up-front tax break, or the bigger tax break down the road?
Lapera: Right. And, depending on where you are in your life, specifically how much money you're making, it can help you decide which one you should get, a Roth or a traditional.
Caplinger: That's true. The thing to think about is, you're going to take two things. Look at how much you would have to pay in taxes now, and compare that with a guess as to how much you would have to pay in taxes when you retire. That's going to guide your decision.
For most people who are younger, their earnings are a bit lower, their tax bracket is pretty low, it generally makes sense to take advantage of the Roth IRA, because even if you get that tax break, it might not be worth very much to you. It might not be worth anything to you, especially if you're in that baby sitting or lawn mowing situation -- you're not going to be in a situation where tax savings amounts to anything anyway. So, moving your money into a Roth IRA instead of a traditional IRA makes a lot more sense.
If you're in the middle of your career, in your high-earning years, it becomes a little trickier. Often, when you're in the highest income period of your lifetime, it makes more sense to go traditional because the tax write-off you get is worth the most, because you're in the highest tax bracket. The tax savings for that write-off is the biggest it's ever going to be.
Lapera: I really wish you had been around when I was 18, when I opened my first IRA, because when I did, I opened a traditional IRA, because I asked the lady at the bank what kind of IRA I should get and she said, "Oh, definitely a traditional." I said, "What's the difference?" And she said, "It's not important." (laughs)
Caplinger: I'm afraid it is important.
Lapera: It is.
Caplinger: It speaks to the fact that there's a lot of confusion out there, even among financial professionals, as far as the ins and outs of IRAs. It's really important for you to check out reputable sources of information to find out what you need to know to make a smart decision.
Lapera: Yes. If you could provide us with ... in biology, we have this thing called a dichotomous key, which helps you identify a species based on what characteristics you observe. Can you provide a dichotomous key for, in summation, how to decide which IRA is best for you?
Caplinger: In general, the first thing to look at is your income. Figure out what your tax bracket is. In general, if you're in that low tax bracket, if you're in a 0-15% tax bracket, your taxes are never going to get any lower. If you're in that situation for whatever reason -- it might be because you're young and you're just getting started, it might be because you've been temporarily unemployed, or you've decided to take a break from work -- for whatever reason, if your income is in that situation, that's going to push you more toward the Roth IRA.
If you're in a high income situation where you're in the 28-39% tax brackets, that's a situation where your taxes are likely -- not necessarily for sure -- to be lower after you retire, so it makes sense to go the traditional IRA route, grab that up front deduction at the highest tax bracket possible now. With the intent that later on, you'll pay tax when you take withdrawals out of that traditional IRA. But it'll be at a lower tax rate. That should help you move forward.
The whole idea here is to end up with the most money at the end of the day. The IRS is going to get its share one way or the other. The question is when it gets it. Your decision is to be as smart as possible and to give them the least that you can get away with.
Lapera: I have a couple follow-up questions. Can you have a Roth and traditional IRA at the same time, and contribute to both of them at the same time?
Caplinger: You can. The annual limit on contributions applies to the total of all IRAs that you put in. For 2016, if you're younger than age 50, you can put in a total of $5,500 into IRAs for the year. If you're 50 or older, you get an extra $1,000, which brings it up to $6,500. You can split that however you want. You can do half in a traditional and half in a Roth. You can do it all in a traditional, you can do it all in a Roth. There is one caveat there, and that is, not everyone is allowed to contribute to a Roth IRA. If you have income above a certain six-figure amount, then you may not be allowed to contribute to a Roth for that year, so the traditional will be your only choice going forward.
Lapera: I think the figure is around $118,000.
Caplinger: I'll take your word for it, Gaby, that sounds about right.
Lapera: Quick break to ask you all a question -- did you know that you can now convert your 401(k) directly into a Roth IRA? I didn't until Dan told me, because that is just one of the things you can find on our 401k.fool.com site, which Dan helped write. It's a pretty great resource for retirement planning and answering questions about 401(k)s.
Let's go back to the show. Remember 18 year-old me? I had accidentally opened a traditional IRA. Now I have a Roth IRA with those same funds that I originally opened. And that was a whole heap of a mess, let me tell you, because I opened my IRA right before Bank of America purchased Merrill Lynch. And Merrill Lynch runs all of Bank of America's IRAs. So my IRA fell into some weird dead zone where no one knew how to access it, because it was on Bank of America's servers, but Merrill Lynch was supposed to be managing the IRAs. So converting it was a nightmare. But I did it. Eventually.
I wanted to convert because I realized that I would get tax benefits from a Roth. Are there any other reasons why you might want to convert from a Roth to a traditional, or a traditional to a Roth?
Caplinger: One thing to keep in mind is, the conversion only goes in one direction. If you have a traditional IRA, you can convert it to a Roth, but in general, you can't go back from the Roth. There's a one-time do-over provision that you do have a limited amount of time to undo a Roth conversion. But in general, once you have the Roth, you're going to keep the Roth. And that's generally what you want to do. Again, as we talked about before, once you get that money in the Roth, everything it earns from there on out is tax-free. Tax-free is good. So you want to hang on to that as much as you can.
Now, the deal with the conversion is, there's a couple situations where you'd want to do it. One is, if you're in that situation we just talked about, where your income is above that threshold amount, you're not allowed to make direct contributions to a Roth IRA, you're still allowed to convert a traditional IRA into a Roth IRA. That can be the end run that gets you into the Roth IRA that you would have chosen in the first place if you'd had that direct option. But instead, the IRS said, "You don't have that direct option, but here's this indirect way of getting into it." That works a lot for people who want to get that diversification, who want both a traditional IRA type of fund and a Roth IRA set aside to hedge their bets and have both things available to them.
Lapera: I have a question about that. If you roll a traditional IRA into a Roth IRA, what are the tax consequences of that?
Caplinger: When you do that, the amount that you convert, you're going to have to include that in your taxable income for the year in which you convert it. So, if you did that conversion today, you would take the money that you converted, and then when you file your 2016 tax return next April, that's when you would include that amount as taxable income on that return.
Lapera: Man, am I glad that I rolled it over when I didn't have a lot of money and the government owed me. (laughs)
Caplinger: That's right, that's the time to do it. And that's a good point. If you're in a situation where you have a temporary loss of income -- whether it's because of voluntarily coming out of the workforce, a layoff or some other source of unemployment -- that can be a good time to think about, "If I convert now, I'm not going to have to pay any income tax at all, or might have to pay a small amount of income tax for this." That might be a price that you should be willing to pay in order to get years or even decades of tax-free growth from here on out, from now until when you retire.
Lapera: I think you said you had a couple other scenarios for why you would want to convert.
Caplinger: Yeah. In general, if you find yourself in a situation where you want to control what your taxable income is, then the Roth IRA can be a good way to do that. If you think forward, for instance, there are a lot of situations in retirement where a certain amount of taxable income are going to have implications for other things. For instance, if your taxable income in retirement is too high, then a portion of your Social Security benefits can end up being taxed.
What many people don't fully understand is, with a traditional IRA, once you reach age 70.5, the IRS forces you to start taking money out of your IRA, whether you want it or not, whether you need it or not. The IRS makes you start taking that money out. Because you're taking that money out of a traditional IRA, it is treated as taxable income in the year you withdraw it. If that boosts your income above that threshold amount, it can have Social Security taxation implications as well.
Coming back, what does that have to do with a conversion? If you convert to a Roth IRA earlier in your career, then when you're taking money out of that Roth IRA, first of all, there's no requirement that you take money out of the Roth IRA. But even if you do, it's not taxed, and it isn't treated as taxable income for purposes of your Social Security benefits being taxable, either. So it's kind of an advanced warning system to get your taxes in retirement under control so that you can foresee and minimize your tax bill not just now, but also when you retire.
Lapera: That's really interesting. Another question just occurred to me -- is there a limit to how many traditional and Roth IRA accounts you can have? Can you have as many as you want, or can you only have one of each?
Caplinger: No, you can split them up however you want. You can have an IRA at a bank, you can have an IRA at a brokerage account, you can have an IRA with a mutual fund company, and there's no limit to the number of accounts that you have.
Now, from a management standpoint, it's often a lot easier if you limit yourself to just one or two of each kind. Otherwise, it gets unwieldy to figure out, "I have $1,000 here and $500 there," and sometimes each account will charge you a separate fee, and then you're paying a bunch in fees that you don't really need to. But no, there's no technical requirement that says that you can't have any more than X number of accounts. That's up to you.
Lapera: You brought up another point, which is another reason you might want to have your money in an IRA instead of a savings account, besides the tax benefits -- you can use that money for something. Like you said, you could have it in a brokerage-type account with your Roth IRA or traditional IRA, and invest in stocks. Or, you can invest it in a mutual fund or an index fund, as opposed to a savings account, where it can't do anything besides sit.
Caplinger: That's right. Just about any financial institution, a broker or a mutual fund company, they will be able to handle IRAs. They can set you up with a retirement account that'll let you get those tax benefits at the same time as giving you a lot of flexibility to invest in whatever it is that you want to invest in for growth.
Lapera: Right. And as we've also talked about on the show a million times, just beating a dead horse, investing in the stock market is one of the best ways to increase your money over the long run, instead of just relying on interest or bonds.
Here's another question that's maybe a little bit morbid -- say you have an IRA and you kick the bucket. Is it difficult to pass that onto your children or whoever you're sending your inheritance to? Does it matter which type it is, or is it about the same?
Caplinger: No, it's actually easier to get IRA money down to your loved ones after you pass away than it is, in many cases, with ordinary assets. You don't need a will or a trust or anything like that in order to do it. IRAs come with what's called beneficiary designation forms. Every financial institution, when you open up an IRA, you're going to see a sheet in all those papers that you have to sign, and it's going to say, "Who do you want your IRA to go to after you pass away?" And there's going to be a bunch of choices. If you have a spouse, there's going to be a special check-the-box for the spouse, because spousal beneficiaries of an IRA have some special rights that non-spouses don't have. Specifically, if your spouse inherits your IRA, they can just take that money and put it into an account in their own name. They can treat it the same way as they treat their own IRA money that they saved themselves.
With a non-spouse, you can't do that, so what you end up with is what's called an inherited IRA. There's some pretty complex rules about how long you can keep money in that inherited IRA, how fast you need to take it out. But in general, the mechanics of getting that money over to the person who you want to inherit that money is very simple. It's just a matter of, you fill out that form, you put their name and information on there, and then when you pass away, that heir can come in to that financial institution and say, "This person named me to inherit this IRA," and then that person will sign the forms that you signed to set it up, and they'll treat it the way they need to treat it going forward.
Lapera: One last question about IRAs. This is actually about 401(k)s. I know that you can now have a Roth 401(k) and a traditional 401(k). Is that correct?
Caplinger: That's right. If your employer gives you the option -- with a 401(k), it's always up to the employer. Not all 401(k)s have a Roth option with them, but if your employer has chosen it, then you have access to it.
Lapera: Right. Just so our listeners know, a 401(k) is a retirement account that's been set up by your employer. They often provide matches. Your employer often matches the amount that you put in up to a certain amount. If you have a 401(k) available to you, I strongly advise you to put money into it.
Lapera: Thank you very much for joining us. Do you have any last thoughts about IRAs or retirement or anything? Caterpillars? Whatever you'd like to tell me about.
Caplinger: I'm not even going to try to struggle with a retirement-based caterpillar analogy. Sometimes it does feel like your retirement savings just inches forward bit by bit. But, even if you can just put aside a little bit in an IRA, that tax break will be much more valuable than you can possibly imagine. You'll be thanking your young self that you did things early on when it would do you the most good.
Lapera: Thank you very much! As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at IndustryFocus@Fool.com, or by tweeting us @MFIndustryFocus if you have any questions.
Apologies to the people who emailed me about the interest rate charts last week, I was out of the office. You'll get those at some point today. Thank you to Austin Morgan, our master mixer behind the glass, and thank you to you all for joining us. I hope everyone has a great week!