Why use an IRA? In a word, Taxes.
Simple, right? Sure, it’s a simple answer. And obvious, too. But it has significant implications. Take a look.
The basic premise for an IRA is to provide a tax-favored way for individuals to save for their retirement. Whether in an IRA or not, most people know that saving for retirement is the responsible thing to do, and saving for it for as long as possible, i.e., starting as young as possible, maximizes the chances that a person will actually have enough to live on in his retirement.
Let’s look at an example where Mary saves for her retirement inside of an IRA and where Kevin saves for his retirement without the benefit of an IRA. Both are 25 years old when they start saving for retirement, and they both do the exact same things and get the exact same return over the next 35 years.
Each year for 35 years, they each take $5,000 of their earned income, after taxes, and put that toward their retirement accounts. Each of them earns 7% annually on their invested money. John’s earnings are taxed at 25% each year, while Mary’s earnings are not taxed because they’re growing in an IRA.
The results: At the end of 35 years, Mary has almost $740,000 in her IRA, while John has only $501,000. A difference of $239,000. At 7%, Mary is earning over $50,000 a year on that amount, and John is only earning $35,000 on his amount.
What’s more is that Mary has been putting after tax money into her IRA, which means the IRA is a Roth IRA. If she decides to retire now that she’s 60 years old, she can start taking money from her IRA, still without paying taxes. She could take only the earnings every year and have over $50,000, tax free, to live on every year.
However, John still has to pay almost $9,000 in taxes on the $35,000 he’s earning every year. Net, he’s only getting $26,000 a year on his investment, while Mary is earning almost twice as much per year.
The only difference was that Mary used an IRA and John didn’t.
The difference becomes even more pronounced if they are able to use specialized investment knowledge or business acumen to increase that annual return significantly. For instance, raising the annual return to only 12% creates a nest egg for Mary of $2.7M, earning $290,000 per year tax free, while John’s nest egg is a mere $1.3M earning $142,000 on which he has to pay over $35,000 in taxes for a net of only $107,000 per year.
That’s a huge difference.
Bottom Line: Use an IRA. Start early (or now, if early isn’t possible any longer) and learn as much as you can about investing to gain that specialized knowledge that will help you to earn significant returns year in and year out. You’ll be glad you did!