There are lots of ways to save for retirement, and one of the most important is the individual retirement account, or IRA. The IRA is a type of account that allows for a reduction in the taxes that you would normally have to pay when it comes to investing. On this page, you can learn more about the characteristics of IRAs, the types of taxes that are involved, and what kind of benefits an IRA can involve.

Taxes on Stocks, Bonds, and Other Assets

When most people invest in stocks, bonds, or other assets, they have to deal with two types of taxes. First of all, they need to pay taxes on their income before they can invest. That is the set of federal, state, and local taxes that get taken out of each paycheck. The money that you actually get in your bank account or check is often called “after-tax dollars” because it is what is left over after taxes.

When you invest after-tax money in something and that asset grows in value, eventually you will want to sell the asset so that you can use the money that you have grown for expenses or purchases. Unfortunately, when you sell the assets, then you have to pay another set of taxes– capital gains taxes. This is why investments are referred to as “double-taxed”– by the time you get money back from your investment, you have had to pay two sets of taxes, which seriously cuts into the value of the investment.

How Taxes for Traditional IRAs are Different

IRAs are special accounts that the federal government has authorized to help reduce the tax burden for people trying to save for retirement. There are two types of IRA: traditional and Roth. Each one allows you to avoid one of the two types of taxes.

A traditional IRA allows for tax-deferred growth. That means you can contribute money to a traditional IRA using “pre-tax dollars”– the money is not subject to income tax. This is resolved by giving you a tax credit that you can apply to your taxes at the end of the year. The money in the account can be invested in stocks, bonds, or anything else. Usually, the bank or financial services company that holds your IRA also provides a set of diversified funds that you can invest in.

You will still need to pay taxes on the accumulated assets in a traditional IRA when it comes time to sell them for cash. For most people, that will be during retirement: there are special tax penalties for withdrawing too early from an IRA account.

Roth IRA Provides another Tax Option

The other type of IRA, the Roth IRA, works the opposite way. You use post-tax dollars to contribute to a Roth, but then the money will grow tax-free, and there is no obligation to pay taxes on the investments once it is time to withdraw from the account. Like the traditional IRA, the Roth IRA should only be used for retirement– you need to pay a big tax penalty if you take money out too early.

Whether to use a traditional or a Roth IRA is somewhat subjective. Often, people base the decision on whether they also have a retirement account through their employer, like a 401k or 403b. If you have a traditional 401k, you might want a Roth IRA, and vice versa.

Calculate and Plan Your Retirement Investments

If you want to find out how your investments are doing, then one good approach is to use a compound interest calculator. For example, if you enter in how much you have saved so far as the principle, then add in your expected rate of return as the interest rate along with how much you plan to contribute on a regular basis, you will get an estimate of how much the investments will be worth in the future.

This is a good way for you to start planning out your retirement. The more information you have, the easier it is to motivate yourself to set up your accounts and start to make contributions. IRAs are important tools on the road to retirement because of their tax benefits, but that can only happen when you are adding more money to the account and letting it grow.

You can use one or both of these to invest your savings, gain compound interest, and avoid some of the taxes that would be due on a regular investment. This can help your money increase more quickly and take advantage of compound interest. The different ways that traditional and Roth accounts manage taxes can be tricky to understand, but it makes a big difference in terms of savings rates.

Traditional Accounts

The traditional account is something that is available to everyone. If you work for a company, then you might have access to a 401(k) plan. If it is a nonprofit like a school, it might be a 403(b) plan instead, but the idea is the same. When you contribute a percentage of your salary to this account for savings, your employer matches some of that and puts more money into the account.

Then you can choose how to invest that money so that it grows. You can use a retirement account even if you don’t have one provided by your employer– an individual retirement account, or IRA, is a similar account that anyone can open and start contributing towards.

Understanding Taxes

Under normal circumstances, money that you invest from your salary income or any other source of income will be taxed twice before you can eventually spend it:

1. It is taxed as income when you earn it. For most people, this will be via regular payroll and employment taxes.
2. You take that post-tax money and invest it in some assets, like stocks and bonds. After you save the money and it grows with compound interest, you sell the investment, and then the money is taxed again with capital gains tax.

In a traditional account, you do not need to pay the first set of taxes, the income taxes. Any money that you contribute to such an account is tax-deductible. You will eventually need to pay the second set of taxes once you finally start to withdraw the funds from the account, but that happens decades into the future. The fact that you can avoid the first set of taxes means there is more money to get compound interest working in your favor on a more considerable starting value, which makes a massive difference over time.

Roth Accounts

A Roth account works the same way, but it allows you to avoid the second set of taxes, the taxes on the gains, once you withdraw the final amount. The advantage of the Roth approach is that you don’t need to consider paying taxes on your retirement income, and you can treat the whole amount as available to use. You will contribute money to a Roth account just like a traditional account, but you do not get to deduct those contributions from your taxes. With most employers, the default retirement account is a traditional 401(k) or equivalent, so you may need to open an IRA and make it a Roth if you want to take advantage of this style.

Mix and Match Retirement Savings

You do not need to commit to one of these account types or the other– you are free to mix and match them. Please take note that they both have annual limits about how much you can add to each one. By putting some of your retirement savings into each type of account, you can hedge your bets about taxation.

The traditional account is better if you believe that your current tax rate is higher than when you will withdraw the money, and the Roth is better if you believe that your future tax rate will be higher than now. This is hard to predict for most people, so putting some money into each kind balances this out and allows for a unified approach.

If you want to understand how your savings will grow, the best approach is to use one of our compound interest calculators. The calculator is very easy to use. Start out by entering an initial amount, which is the first contribution to your account. Then enter a 12 month period and how much you expect it to grow each year, how long you plan to leave it in the account, and the frequency and amount of contributions. Finally, it’s a good idea to make some different scenarios for the growth rate so you know what to expect under different circumstances for your investment.

Roth Conversions Explained

The main difference between a Roth IRA and a traditional IRA is when you pay taxes on the money. With a Roth IRA, your contributions are taxed before they are applied to the account. This means that when you are ready to withdraw the money during your retirement, you will not have to pay any taxes at that time. With a traditional IRA, your contribution is made with before-tax dollars, and you will have to pay taxes when you begin receiving distributions. This means you will see a larger paycheck during your contributing years, but you will pay when you withdraw the money. 

Roth IRAs have several other advantages, such as they do not require minimum distributions. You can also pass on Roth IRA assets to your heirs tax-free. In addition, some accounts allow you to convert your traditional retirement account to a Roth IRA. Some people do this to avoid the required distributions of traditional IRAs and allow their money to continue growing tax-free. 

The catch is that because you have not already paid taxes on the money in the Traditional IRA, you might have to pay the taxes owed at the time when you do the conversion. To make the decision, you have to calculate how much you would the gain in interest if you left the money in the account.

Input the relevant principal, interest rates, and how much longer you will be contributing until your retirement. The calculator will provide your expected retirement savings at the end of the time period. Compare that amount versus any taxes or fees you would pay to make the conversion. At least, this is how it works if you are the average person with an average income level. This might not be the case if you happen to be a billionaire. 

What Are the Proposed Changes?

Currently, many accounts are available for conversion to a Roth IRA, but they have to follow specific rules. The proposed changes would eliminate back-door conversions for those with giant tax-sheltered IRAs. The Roth IRA was developed to help middle-class Americans save more for their retirement. In addition, it was meant to ease the tax burden on those with average incomes so that they would not have additional taxes at a time when their earning potential is reduced.

This new proposal came about because it was found that billionaires, such as Peter Thiel, were using their Roth IRAs as a tax shelter for millions of dollars of capital gains from investments. A third-party investigation found that Thiel had approximately $5 billion in his Roth IRA.

Thiel, and others, were able to enjoy the tax-free accumulation of wealth using a loophole in the Roth IRA law. How it worked is that Thiel started his Roth IRA account with shares of his new startup company, Paypal. At the time when he opened the account, the shares were valued at under $2,000 total. After that, the company grew, and as it did, the value of the shares in his Roth IRA account grew to the $5 billion mark. 

The catch is that all of this money grew and was treated as if taxes had already been paid on it, as it would be if it were a regular contribution from a paycheck. For the average American, most had already paid taxes that were deducted from their paycheck before the contribution was taken out and put into their Roth IRA account.

The money in Thiel’s account grew without passing through the system that applies to most Americans. Because it was not from the sale of a stock, he never had to report it on his taxes as a capital gain and pay taxes on it. It was never taxed as income. He can then withdraw the money tax-free at age 59 ½, never having paid any taxes on the money at all. The proposed law would eliminate this loophole for the ultra-wealthy. 

Who Would It Affect?

Changes would only affect those with retirement accounts that exceed $10 million and those with an annual income of over $400,000. Those with balances in their retirement account of over $20 million could be forced to make withdrawals. Roth conversions would not be allowed for these retirement accounts.

For most, these new changes will not have an effect because it only affects those whose retirement accounts exceed these thresholds. The major impact that it will have is that it cuts out a tax loophole for wealthier Americans, but most will not see a difference in their accounts.

Have you ever thought about investing in STRIPS? If so, you probably have at least a basic idea about what government-backed securities are and how they work.

The acronym’s letters stand for “Separate Trading of Registered Interest and Principal Securities.” Still, when you purchase them through a broker (individuals can’t buy them directly), you’ll notice that they’re just called “STRIPS” for short.

STRIPS: The Basics

STRIPS are the separate interest coupons that were once attached to long-term bonds with maturities of 10 years or more. When you buy one, you’re not purchasing the bond but just the coupon.

Then, semi-annually, you receive the interest payment due on the original bond. So, in a way, STRIPS operate like zero-coupon bonds because investors buy them at a discount from the face amount of total interest.

Another critical characteristic of these federal-government-backed instruments is that you can’t buy them directly from the US Treasury but must go through a broker or banking institution.

STRIPS come with a unique set of advantages and disadvantages and a relatively unique form of tax treatment. To gain a complete understanding, it’s best to begin by assessing the good and bad points of STRIPS.

Pros of Treasury STRIPS

Very few STRIPS are inflation-adjusted, so the interest payout amounts are exact, known, and fully guaranteed by the US government. Therefore, for investors who want to have a specific amount of money available at a precise time in the future, STRIPS are ideal.

Pricing is 100 percent transparent, and you can get a full menu of what maturities and original bond amounts are available from your broker, who will charge a small fee for doing the transaction.

Otherwise, STRIPS are a low-cost way to park long-term investment capital. You’ll never be in the dark about what the payout is or when it is going to occur. Unlike stocks, you’ll never have to stay up on economic and financial news to find out how your STRIPS are doing. Payouts are static and assured.

Cons Treasury STRIPS

As is the case with every type of investment under the sun, STRIPS have their downside. As well, there are certain groups of investors who should not even consider buying them.

For instance, if you miscalculate your need for cash, there’s a chance you might have to sell a STRIPS before it matures. In that case, you stand to lose out for two reasons. First, the secondary STRIPS markets is not always as active as traditional securities and bond markets.

So, you could face a problem of liquidity when you decide to sell early. Second, early sales (before the STRIPS mature) could trigger a tax event in the form of capital gains or losses. That means additional tax figuring and potentially higher tax bills.

Finally, compared to stocks, forex, and many other traditional investment vehicles, STRIPS don’t come with an attractive ROI (return on investment). So consider all your options before locking money into these relatively long-term bond hybrids that are almost the polar opposite of corporate stocks.

What Types of People Purchase STRIPS?

Investors of all kinds can use STRIPS to diversify a portfolio. But as stand-alone instruments, STRIPS are best-suited for people who want to plan for successive payouts every six months or in a lump sum at some time in the future. It’s important to realize that most STRIPS owners use a “ladder” approach, in which they buy the instruments at successive maturity dates, six months apart.

For people who are about a decade away from retirement, laddering can be a smart way to augment a standard pension or IRA. Likewise, you can hold STRIPS in an IRA to simplify and magnify the value of the payouts.

What About Taxes?

Owners of these instruments must pay tax on the accrued interest each year, a process that’s simplified with the issuance of an official form from your brokerage. However, as long as you pay the interest each year, there’s no big, one-time tax bill at maturity.

It’s possible to avert the paperwork of annual tax filing on STRIPS by simply holding them in either a traditional or ROTH IRA. Then, at maturity, you’ll pay your ordinary income tax rate on the total amount of accrued interest if you own a traditional IRA.

Keeping STRIPS in a ROTH IRA has the double advantage of using after-tax money to purchase them and never having to worry about annual interest reporting or ever paying on the accumulated interest at maturity.