April 19, 2014

Traditional IRA Investing Guide for 2013

To answer questions about investing through a Traditional IRA, how a Traditional IRA works, and whether it is better to use one than a regular brokerage account, I am publishing this rundown on the topic, along with a matching piece that looks at the Roth IRA. It’s meant as a sort of quick-reference guide for those of you who are considering it and want to have a general idea of how these things work before consulting with your own qualified adviser.

What Is a Traditional IRA?

Before we get into the details, let me walk you through the basics. A Traditional IRA, short for Traditional Individual Retirement Account, is a special type of account that you can open at a bank, brokerage firm, mutual fund company, or other financial institution. It is not a type of investment. This account can invest in things such as stocks, bonds, mutual funds, and real estate, depending on the options provided by the company with which you open your Traditional IRA. For example, if you go down to the local bank, the odds are good they are only going to let you pick from money market accounts and certificates of deposit. If you open a Traditional IRA at a brokerage firm, instead, you could buy shares of Coca-Cola, low cost index funds, or corporate bonds.

You are allowed to put a certain amount of money into a Traditional IRA each year if you qualify based on the rules in effect for that year. In most cases, unless you have too high an income, you will receive a tax deduction, saving you money on your Federal, state, and local tax bill. Even better, any money in the account is tax-free while it remains inside the protection of the Traditional IRA. That means you don’t pay any taxes on dividends, interest, rents, or any other profits you earn.

Later, when you go to withdrawal the money during retirement, you treat the cash as if it were ordinary income and pay taxes on it then. By this point, if you are an ordinary citizen with a middle class income, you should have enjoyed decades of tax-free compounding, plus a big tax deduction back in the day.

Got all that? That’s the forest-level view. Now, let’s look at the individual specifics that govern the Traditional IRA rules for 2013.

Tax Deduction Eligibility Phaseout on Contributions to a Traditional IRA

With a Traditional IRA, your contributions are tax-deductible at the time, depending upon your income level. These phaseout limits only determine whether or not you can write the contribution off your taxes; you can still contribute to a Traditional IRA even if you exceed them. The phaseout limits are determined based not only on your filing status, but whether you or your spouse are employed by someone else who offers a retirement plan, such as a 401(k), or are self-employed.

In tax year 2013, you begin to lose the tax deduction at the following levels if you are covered by a retirement plan at work:

  • Single filers: $59,000 or less gets a full deduction, $59,001 to $69,000 gets a partial deduction, $69,001 or more gets no deduction.
  • Head of Household filers: $59,000 or less gets a full deduction, $59,001 to $69,000 gets a partial deduction, $69,001 or more gets no deduction.
  • Married Couples Filing Jointly: $95,000 or less gets a full deduction, $95,0001 to $115,000 gets a partial deduction, $115,001 or more gets no deduction.
  • Qualifying Widow or Widower: $95,000 or less gets a full deduction, $95,0001 to $115,000 gets a partial deduction, $115,001 or more gets no deduction.
  • Married Couples Filing Separately: $9,999 or less gets a partial deduction, $10,000 or more gets no deduction.

In tax year 2013, you begin to lose the tax deduction at the following levels if you are self-employed:

  • Single filers: Any income gets full deduction
  • Head of Household filers: Any income gets full deduction
  • Married Couples Filing Jointly Where Both Spouses Are Self-Employed: Any income gets full deduction
  • Married Couples Filing Jointly Where One Spouse Is Covered By a Plan at Work: $178,000 or less gets a full deduction, $178,001 to $188,000 gets a partial deduction, $188,001 or more gets no deduction
  • Qualifying Widow or Widower: Any income gets full deduction
  • Married Couples Filing Separately Where One Spouse is Covered By a Plan at Work: $9,999 or less gets a partial deduction, $10,000 or more gets no deduction

Traditional IRA Contribution Limits

You can contribute to a Traditional IRA if you are less than 70.5 years old and you have what the IRS refers to as earned income (wages, self-employment income from farming, self-employment income from a business, or alimony). How much you can contribute depends on your age. For tax year 2013, your contribution limits are as follows:

  • $5,500 if you are 49 years old or younger
  • $6,500 if you are 50 years old or older

The money you have sitting in your Traditional IRA gets to avoid all taxes while it is working inside the protection of the account. That means for decades, all of the dividends, interest, rents, capital gains, and other profits you earn on the holdings inside the Traditional IRA are 100% yours. You don’t have to share them with the Federal, state, or local government. The only problem you may run into is if you buy foreign assets, such as French dividend stocks, which will result in the foreign government withholding some of the dividend income that you cannot recapture. (As a general rule, certain nations are exempt from this. An American investor putting together holdings for a Traditional IRA is almost always going to prefer stocks from places such as the United Kingdom, because there is a 0% withholding rate in effect due to a tax treaty with the United States.)

Making Withdrawals from Your Traditional IRA

When you are ready to make a withdrawal from your Traditional IRA, your tax situation depends on your age.

  • If you are younger than 59.5 years old, and don’t qualify for an exemption, you will pay Federal, State, and local tax on the withdrawal plus a 10% penalty tax for breaking into your retirement fund early.
  • If you are 59.5 years old or older, you will pay Federal, State, and local tax on the withdrawal.

You must begin making withdrawals from the Traditional IRA no later than 70.5 years old, and your accountant or tax adviser will need to do a somewhat complex formula to determine the minimum amount you must take out each year based on your life expectancy.

The Exemptions to Avoid the Early Withdrawal Penalty on Your Traditional IRA

This means that it is patently stupid, in virtually all circumstances, to make a withdrawal from a Traditional IRA before you are 59.5 years old unless you can qualify for one of those exemptions. These Traditional IRA exceptions include:

  1. Withdrawals taken to cover non-reimbursed medical expenses that exceed 7.5% of your adjusted gross income
  2. Withdrawals taken to pay health insurance if you are unemployed, have received unemployment under any state or Federal law for 12 consecutive weeks, take the distribution in the year in which you were unemployed or the following year, and the money was taken out of the IRA no later than 60 days after you found a new job.
  3. Withdrawals taken if a medical doctor declares you mentally or physically disabled to the point you cannot support yourself through gainful employment
  4. Withdrawals taken by first-time home buyers for expenses and closing costs, up to a maximum of $10,000
  5. Withdrawals taken to cover certain higher education expenses, such as college tuition, textbooks, and university fees
  6. Withdrawals made by non-spouse beneficiaries who inherited a Traditional IRA from the now-deceased. If you were married to the original IRA owner, this does not apply and you have a certain window of time to rollover the money into your own Traditional IRA.
  7. Withdrawals taken to pay a non-voluntary IRS levy
  8. Withdrawals taken by certain guard and military reservists who are called to active duty on any date after September 11th, 2001 made during the active duty period
  9. Withdrawals taken under a complex formula called “substantially equal periodic payments” that requires the advice of a good tax accountant or attorney

The Benefits of Using a Traditional IRA to Invest for Retirement and Your Heirs

The benefits of investing through a Traditional IRA should be immediately obvious. You get an immediate tax deduction, plus get to enjoy decades of tax-free compounding. When you begin making withdrawals, you pay ordinary income tax on the money. Even if you end up in a much higher tax bracket by retirement, the time-value-of-money benefits of compounding uninterrupted for long periods of time more than makes up for the difference in many cases.

On top of this are things that people don’t often consider. If you suddenly find yourself bankrupted, many courts are loathe to violate a person’s Traditional IRA. There are always exceptions, and this isn’t absolute, but the reason comes down to the fact that the money put aside in the account doesn’t actually belong to you – you are simply the person it is intended to benefit. That is the reason you can’t pledge your Traditional IRA assets as collateral for a loan or it is immediately considered a withdrawal, complete with penalty. It’s not your money until you take it out during retirement. That means if you are wiped out entirely, the best chance you have to hold on to some of your assets without having to start completely over is to have them parked in the protection of an account such as a Traditional IRA. That is one of the reasons I get so frustrated when people write me; they will have run into financial trouble and spent years draining through their IRA balances only to declare bankruptcy when the money is gone. It’s a stupid way to behave. They should have consulted a bankruptcy attorney much earlier in the off-chance the debts could have been discharged and the Traditional IRA balance preserved. Good attorneys are valuable. Seek their advice; they spend their careers knowing the laws of the state and you are buying their expertise. This is not one of those areas that a do-it-yourself approach works.

All else equal, most people will end up with substantially more wealth by investing through a Traditional IRA than they would a regular, plain vanilla brokerage fund. The downside is there is no using the money until you are 59.5 years old unless you want to get hammered with that penalty rate. A quick run-through of the numbers will show you the reason.

Let’s imagine you are 25 years old with an effective combined Federal, state, and local tax rate of 25%. You contribute $5,500 to a Traditional IRA and it lowers your tax bills by $1,375. At this point, you take that money you would have paid to the government and put it in a brokerage account. Right away, you have $1,375 in extra money working for you in what amounts to an interest-free loan that will remain in effect until you start making withdrawals between the age of 59.5 years old and 70.5 years old; that’s 34.5 to 45.5 years of cost-free money.

Now, you have two piles of cash:

  • $5,500 sitting in a Traditional IRA
  • $1,375 sitting in a brokerage account

You’re already much better off than you would have been.

From here, we have to make a lot of assumptions, and some of them are going to be rough because you get a certain amount of dividends tax-free before you have to begin paying, some dividends are “qualified” and enjoy a Federal tax rate of 15% instead of the higher tax bracket rate that can go up to 39.6%, some states have no income tax, some only tax dividends and interest, and some treat it all the same.

We do know from every major reputable academic source, including the industry gold standard Ibbotson & Associates yearbook of statistical information on asset class returns, that over practically all 25-year rolling periods since detailed records were kept in 1926, the United States stock market, with dividends reinvested, has returned approximately 10% if you owned a diversified collection of blue chip holdings (smaller stocks returned 12% but carried more risk). This averages out periods like the Great Depression and the Great Recession, where the whole world was falling apart, and euphoric bubbles like the Go-Go era in the 1960′s and the dot-com boom in the 1990′s.

(This figure sometimes surprises the inexperienced, but it’s the same phenomenon you see when a new investor doesn’t understand how you could have made 4x your money owning Eastman Kodak over such a time span, even though the company ultimately went bankrupt and the stock worthless. Dividends matter. Spin-offs matter. Yet, neither show up in 99% of the stock charts despite some of the best research in the field of business academia showing those two factors contribute more than 99% of real, after-tax, inflation-adjusted returns from stock holdings. It’s somewhat paradoxical, but to the long-term investor, periods like the Great Depression are gifts because the dividends get plowed back into buying more shares at huge discounts. Later, it takes only a tiny advancement in the economic recovery to more than make up for the losses.)

Still, we can guess that if the stocks held in the Traditional IRA are left alone and generate the average rate of return, between taxes on capital gains and dividends, the fully taxable brokerage account will probably suffer a 1.5% handicap or so, depending on the level of turnover, relative to the retirement account.

Projecting out to 59.5 years old, the two accounts would be worth:

  • Traditional IRA: $147,370
  • Brokerage: $22,942
  • Grand Total: $170,312

Of course, the brokerage account is likely going to have substantial capital gains built in as a result of holding for decades, which are currently taxed at 15% plus state. Meanwhile the Traditional IRA is going to see any withdrawals taxed as ordinary income. Ultimately, there won’t be that big of a difference for a vast majority of taxpayers. They will be much better off, though, because of the extra 1.5% of compounded they received in the Traditional IRA over the years, which gave them an extra $55,603.

Projecting out to 70.5 years old, the two accounts would be worth:

  • Traditional IRA: $420,465
  • Brokerage: $56,280
  • Grand Total: $476,745

Again, in this case, provided the withdrawals are taken over several years to maximize tax efficiency, the Traditional IRA structure would have added around $195,344 in excess wealth due to the higher effective compounding rate.

The downside, of course, is that if you pass away while you still hold assets in the Traditional IRA, the account doesn’t receive a step-up cost basis like almost all of your other assets do. The practical effect of this are virtually nill, fortunately, because your heirs could simply sell the assets wtihin the Traditional IRA before making a withdrawal of the cash, then turn around and repurchase the same investments in a regular brokerage account shortly thereafter, sidestepping the problem entirely.

Conclusion About Investing Through a Traditional IRA

The bottom line? In my opinion, investing in a Traditional IRA is almost always superior to the brokerage-only alternative if you are talking about building money for retirement and heirs. However, it is vastly inferior to the Roth IRA, which beats it in almost every respect. I believe strongly that the Roth IRA is going to be a better match for almost all people, almost all of the time, though you’d have to speak to your own adviser about your unique circumstances.

  • weixiluo

    Joshua, I think you added an extra 0 in the Traditional IRA Contribution Limits section for 49 years old and younger …

    • http://www.joshuakennon.com/ Joshua Kennon

      Thanks for catching that; I’m about to go running and haven’t done the final edit, yet. I’m sure there are probably a few more typos that I’ll try to get corrected when I get back. I just submitted this fix; it should show up soon.

  • Anon

    Vanguard, Vanguard, Vanguard

    • http://www.joshuakennon.com/ Joshua Kennon

      They definitely have the most favorable fee and expense structure I’ve seen on low-cost index funds, Roth IRAs and Traditional IRAs (I’m not so crazy about the ETFs). An investor with only a few thousand dollars buying something like a passive dividend fund through them can get the same expense ratios I get buying larger blocks of shares outright and holding them through a traditional brokerage firm.

      Case in point: It is truly bordering on the absurd that a $10,000 investment in the Vanguard 500 Index Fund Admiral Shares would result in a 0.05% expense ratio. That’s $5 per year. Five bucks. It’s just obscenely low. Some of the private banks charge 20x to 30x as much for what amount to almost identical offerings, plus they might levy a $50 commission on each purchase!

      • Anon

        I’m in complete agreement!

      • Anon

        You mention, “I’m not so crazy about the ETFs.” Why is that?

        • Anon

          (I, the original Anon, did not ask this question.)

          There are pros and cons to ETFs. Some ETFs allow you to easily access index funds with very high minimums. Also, a good deal of the time the expense ratio on the ETFs can be lower than the corresponding mutual fund.

          As for cons of ETFs, you can’t buy fractional shares. Bid-ask spread. With mutual funds it’s easier to move from one mutual fund to another, since it’s based on the close of business net asset value of both mutual funds. With mutual funds there is quicker dividend reinvestment. With mutual funds you may save yourself from itchy trigger fingers and attempting to trade/speculate throughout the day. With mutual funds, scheduled automatic investing–auto pilot–($100 in energy fund on the 1st of every month, for example) is easier.

        • http://www.joshuakennon.com/ Joshua Kennon

          I agree with the other Anon’s response to your question. He provided a lot of the specifics that cover some of my problems.

          There is also the philosophical issue. There is no reason for an investor to need a basket of securities to trade like a stock, rather than settling at the end of the day, except for the purpose of hyperactivity and speculation. It essentially has the net effect of expanding the size of Wall Street and redeploying productive capital from the Main Street economy into the banking and financial sector without any corresponding increase in utility for the average citizen. It’s generally more expensive than comparable mutual fund offerings. It also defeats the purpose (e.g., if you want to own gold as an inflation hedge and security, why wouldn’t you hold it physically? What makes you think ti won’t be confiscated just like it was in the 1930′s?)

          These were a product invented for the uninformed masses on one hand and speculators on the other, designed to do nothing but raise money for non-productive financial institutions. They do nothing for the real economy. They are a subpar holding structure for the long-term securities owner. They encourage a lot of stupid behavior, especially now that you have things like “triple net long” or” triple net short” ETFs.

        • Michael Starke

          That last paragraph contains an interesting point. Yet, how realistic is that as a strategy for you? I would have expected that you would have “files” on quite a few prospects already lined up to be reviewed (and quickly acted upon) in a “blood in the streets” type scenario. Or does it have more to do with a lack of comfort valuing particular verticals?

        • http://www.joshuakennon.com/ Joshua Kennon

          In the 1942 edition of The Intelligent Investor, Ben Graham actually used two pharmaceutical companies, both reasonably valued, both successful, as a case study, comparing Abbott Laboratories to Parke Davis. Then, showing that the best performing equity in the field over that time was Sharp & Dohme, which looked terrible initially. Graham’s conclusion is one I can’t argue against. He said, “The best opportunity in the field of drug stocks turned out to be where it was least expected – an all-too-frequent happening.”

          You are right that I have files on several companies, and I also have preferences among them at the moment, having bought a few individual issues for either my own household accounts or those of my extended family. My brother owns shares of GlaxoSmithKline, while my parents have a long-term position in Novartis. I almost always prefer making specific selections based upon a rational understanding of the facts and valuation presented but this is a problem in the drug sector. In a business like pharmaceuticals, when the company itself is not a diversified conglomerate (e.g., Johnson & Johnson), I think the basket approach is probably more appropriate when and if you are dealing with what appears to be widespread industry undervaluation. Not even those in the research lab can tell you which firm will stumble upon the next Lipitor, Plavix, Viagra, Nexium, or Abilify.

          Were I to think that the drug stocks, en masse, were cheap, I would probably pick up a low-cost industry-specific ETF or passive fund specifically devoted solely to that area as a sort of Graham-like value play. Otherwise, I’d tend to look at specific companies, at specific times, and make a purchase. It’s hard for me to not feel strongly that Novartis is a better deal at the moment than Bristol-Myers Squibb, to illustrate the point, but this business is unlike most other industries; tomorrow, Bristol-Myers Squibb could stumble across a compound that extends lifespans by 30 years and suddenly be worth far more than its current intrinsic value. No amount of analysis will allow someone to project when and where that might happen – or when a dry spell will occur. It’s easy to value a Coca-Cola or even a General Motors. No matter what anyone tells you, or how confident they are, arriving at an intrinsic value figure based on contingent factors is far more difficult for a Pfizer. Hence, one should require a much larger margin of safety.

          In other words, depending on the specific situation, it’s entirely a possibility this would be one area where I would go back to the 1930′s and 1940′s approach of the great value investors and decide to make what amounted to an insurance underwriting bet on an entire sector, which I’d then hold for a long period of time and extract the dividends for use elsewhere. I haven’t done it, yet, but I would certainly be open to the possibility.