The Benefits of Investing With Your IRA
[Note: The following is offered for informational purposes only. EquityZen does not provide tax advice. For information about your particular tax situation, please contact your personal financial advisor.]
It’s hard to get excited at the idea of an individual retirement account, or IRA. It’s all about long-term thinking, building up slowly over the years in anticipation of a far-off (or maybe not so fa-off) future retirement. In fact, many of us don’t even know what’s in our IRA portfolios.
And that’s a missed opportunity.
Investing with your IRA can be an extremely advantageous way to build wealth over the long haul, but there is a lot of convoluted information out there about how to actually do this. Fortunately, investing through your IRA isn’t as complicated as it seems. Let’s break down what IRAs really are and how they can help you maximize your portfolio for the best long-term returns.
What is an IRA?
An IRA (or individual retirement account) is an investment account designed for long-term retirement savings. Among the signature features of the IRA are its numerous tax advantages (more on this below). You can open an IRA through your regular brokerage or bank, although each provider has unique offerings; in most cases, you and/or your spouse simply need to earn an income to qualify for an IRA account.
There are several different types of IRAs—traditional IRAs, Roth IRAs, SIMPLE IRAs, simplified employee pension (SEP) IRAs, rollover IRAs, and more. Each type of IRA offers unique advantages, and determining which one is right for you will depend on your investor profile and overall goals. (Talk to your financial advisor to learn if you qualify for a non-standard IRA.)
But the two most popular (and most likely to fit the needs of the average investor) are the traditional IRA and the Roth IRA.
Each of these types of accounts allow you to contribute up to $6,000 per year (if you’re under 50) or $7,000 (if you’re over 50) and have earned at least that much in income during the course of the year. You can withdraw your money at any time from your IRA account, but if you do so before the age of 59-and-a-half know that you may likely be subject to a hefty tax bill and other penalties (unless you qualify for an exception).
Tax Advantages of an IRA
As mentioned above, IRAs offer major tax benefits to their holders.
With a traditional IRA, you can deduct your contributions for the year you made them (if you qualify). Your money can grow on a tax-deferred basis until you withdraw the funds—at which point it’s taxed as normal income. If you can wait to withdraw the money until retirement, you may find yourself in a lower tax bracket, in which case you’d be taxed at a lower rate.
With a Roth IRA, contributions are made with after-tax money. In other words, you can’t deduct your contributions at the time you make them. But the money grows tax-free, and any withdrawals you make after age 59-and-a-half are not taxed. Also, you can generally withdraw any money you contributed (although not any gains) tax free and with no penalty. If you expect to be in a higher tax bracket once you retire, a Roth IRA is a good way to overcome that excess tax.
The long and the short of it is that IRAs allow you to hold onto some extra cash for retirement, or reinvest it and pocket even more gains.
Investing in Long-Term Assets Through an IRA
Stocks and bonds may be easy to buy and sell quickly, but your retirement portfolio probably includes some less conventional holdings, and those aren’t always quite so simple. Assets like real estate, collectibles, art, or niche markets can be highly illiquid, meaning they’re harder to sell on the open market, which means they’re harder to take disbursements from.
The conundrum is that after age 70-and-a-half, you must begin taking required minimum distributions (RMDs) from your traditional IRA, even if it includes illiquid assets.
And you don’t want to skip your RMD. The term “required” isn’t just for show. If you don’t take it, you can expect a whopping 50% (yes, you read that correctly) penalty on the amount of the RMD you didn’t take. And the penalty doesn’t buy you any privileges—you still have to take the RMD anyway.
So how do you meet the requirement if your IRA has low liquidity?
If you have another IRA, you can take your RMD for the illiquid account from the more liquid one.
If you only have one account, you could compensate for any illiquid assets by adding some more liquid holdings to your account.
If that’s not a feasible option, then you would need to take what’s called an “in-kind” distribution. Simply put, this is when the IRA transfers a portion of the asset into your name. In more detail, the IRA custodian writes you a 1099-R showing a portion of the asset’s value has been distributed to you. This is taxed as gross income.
Of course, all of this could be avoided by investing in a Roth IRA instead, as these have no RMDs. If you already have an IRA and prefer not to have any RMDs, you can roll over the assets through what’s called a Roth conversion.
Which Type of IRA is Best?
Determining which type of IRA is right for you depends on your personal situation. When choosing an IRA, consider:
- What your current tax bracket is vs. your expected tax bracket when you retire. If you expect it to be higher, a Roth IRA would be more advantageous from a tax standpoint.
- Do you want to deal with RMDs in retirement or not?
- If you are OK with RMDs, does your account hold alternative assets that have low liquidity? You’ll need a plan to deal with them once the time comes.
Regardless of the type, an IRA is an important part of anyone’s long-term investment strategy. Make sure you’re utilizing it to its fullest potential.
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At EquityZen we recommend using AltoIRA to fund an IRA account.