True Vine Investments Originally Published in September 2011.!

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1 True Vine Investments Originally Published in September Updated in March 2014 to reflect 2014 IRS numbers. Understanding Individual Retirement Accounts (IRAs) Part 1: IRA Basics This educational publication is designed to provide a background for understanding the advantages of using Individual Retirement Accounts. It is not a substitute for professional tax advice. Readers considering the implementation of an IRA are encouraged to discuss and review their specific plans with a tax professional. True Vine Investments will not be held responsible for negative implications arising from the use of the information presented. Interested readers are encouraged to obtain Publication 590 from the Internal Revenue Service, which covers the specifics of Individual Retirement Arrangements (IRAs). Individual Retirement Accounts ( IRAs ) were originally created by the U.S. government in 1975 to assist workers in saving for retirement. The fundamental incentive for an individual to use an IRA instead of a regular bank or brokerage account is tax savings. Over an extended period of time the tax savings can really add up. Consider the following hypothetical example of Peter and Paul. Table 1 Year Maximum IRA Contribution Allowed Peter s Peter s Additional Paul s 1990 $2,000 $2,000 $300 $2, $2,000 $4,200 $615 $4, $2,000 $6,620 $946 $6, $2,000 $9,282 $1,293 $9, $2,000 $12,210 $1,658 $11, $2,000 $15,431 $2,041 $14, $2,000 $18,974 $2,443 $17, $2,000 $22,872 $2,865 $21, $2,000 $27,159 $3,308 $24, $2,000 $31,875 $3,773 $28, $2,000 $37,062 $4,262 $33, $2,000 $42,769 $4,775 $37, $3,000 $50,045 $5,464 $43, $3,000 $58,050 $6,187 $50, $3,000 $66,855 $6,946 $57, $4,000 $77,540 $7,894 $66, $4,000 $89,295 $8,888 $75, $4,000 $102,224 $9,933 $85, $5,000 $117,446 $11,180 $97, $5,000 $134,191 $12,488 $110, $5,000 $152,610 $13,863 $123,916 Totals $166,473 $123,916 Assumptions: 1. Both save the equivalent of the maximum allowable IRA contribution each year % average income tax rate 3. 20% average capital gains and dividend tax rate 4. 10% return on invested savings 5. Peter invests the additional amount saved through the annual income tax deduction and earns an average annual return of 5% on it. Peter and Paul are both professional lobstermen that have been in the business for twenty years. They both work for Red Claw Enterprises, based out of Bar Harbor, Maine, which does not offer a company retirement plan for its workers. They are equally successful. They both took home about $75,000 in income during They are also both savers. Since 1990, when they started working for Red Claw, they have both been putting money away. The only difference between the two is that Peter has always been more tax savvy. After conducting his own research, he began putting his savings into a Traditional IRA after learning that (1) the contribution was tax deductible and (2) that there was no tax 1

2 True Vine Investments Originally Published in September Updated in March 2014 to reflect 2014 IRS numbers. Understanding Individual Retirement Accounts (IRAs) Part 1: IRA Basics on the dividends and capital gains that his investments earned. He would only have to pay tax on the distributions he eventually took from the IRA during retirement. Paul put all his savings into a regular taxable brokerage account. Table 1 reveals how the two have faired over the last twenty years: Twenty years of IRA investing for Peter would have netted him $166,473. This is $42,557 more than Paul s savings of $123,916 in his taxable account. If the same pattern were to continue for another ten years (30 years total) Peter would have a nest egg of $525,357 versus $354,444 for Paul, a difference of $170,913. Peter s savings would be 48% larger than Paul s. That is the power of tax deferred compounding available through an IRA. It is important to understand that an IRA is a type of account, it is not a specific type of investment. The return achieved by the IRA depends upon the investments held by the account. An IRA is not a specific investment that promises a certain rate of return, like a certificate of deposit (CD) offered by your local bank may. An IRA account can be held with a bank, credit union, brokerage, or life insurance company. The IRA account can hold investments in CDs, money market funds, mutual funds, exchange traded funds, stocks, bonds, annuities, and according to IRS Publication 590: Your IRA can invest in one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or oneounce silver coins minted by the Treasury Department. It can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion (page 48). An IRA account cannot invest in life insurance and collectibles (e.g., artwork, antiques, gems, stamps, coins, and wine). As the name implies, Individual Retirement Accounts are for individuals not for married couples. Each spouse will have their own separate account(s). There are two primary types of IRAs, the Traditional and the Roth. A Traditional IRA is generally funded with pre-tax contributions, while the Roth IRA is funded with after-tax contributions (earned income you have already paid tax on). Traditional IRAs are generally more beneficial for individuals expecting to be in a lower tax bracket in the future, such as their low income retirement years, while Roth IRAs are generally better options for individuals expecting to be in a higher tax bracket in the future. The Traditional IRA is geared towards paying taxes later, while the Roth IRA is geared toward paying taxes now. Another current consideration is the value of the dollars you are being taxed on (i.e., their purchasing power). If the value of the dollar falls precipitously it may be better to defer paying tax for that reason alone (assuming there still is a dollar when you pay the future taxu) and pay it later with depreciated dollars The Traditional IRA offers tax deferred compounding of investment earnings and gains and the Roth IRA offers potentially tax free investment earnings and gains, when held for the appropriate amount of time (see How are distributions taxed? in Table 2). If you have substantial returns on your 2

3 True Vine Investments Originally Published in September Updated in March 2014 to reflect 2014 IRS numbers. Understanding Individual Retirement Accounts (IRAs) Part 1: IRA Basics investments over an extended period of time, the tax savings is considerable. Table 2 highlights the important attributes of each. Table 2 Conditions (if applicable) Traditional IRA Roth IRA Who can establish? An individual who has taxable compensation spouse under age 701/2. An individual who has taxable compensation and whose modified adjusted gross income is less than: $191,000 (filing status: married filing jointly or qualifying widower) $10,000 (filing status: married filing separately and you lived with your spouse at any time during the year) 4 $129,000 (filing status: single, head of household, or married filing separately and you did not live with your spouse at any time during the year). Are contributions tax deductible? If you are single and not covered by an employer retirement plan or married and neither spouse is employer plan. Yes No If you are not employer retirement plan, but your spouse is. Yes, if your modified adjusted gross income is $191,000 or less (married filing jointly filing status) or $10,000 or less (married filing separately filing status and you lived with your spouse at any time during the year). No If you are employer retirement plan. Yes, if your modified adjusted gross income is: $70,000 or less (single or head of household filing status) $116,000 or less (married filing jointly or qualifying widower filing status). No 3

4 True Vine Investments Originally Published in September Updated in March 2014 to reflect 2014 IRS numbers. Understanding Individual Retirement Accounts (IRAs) Part 1: IRA Basics Conditions (if applicable) Traditional IRA Roth IRA How much can I contribute? Is interest, dividends, and capital gains from investments taxable each year? How are distributions taxed? $5,500 $6,500 if you will be age 50 or older by the end of 2014 No Distributions representing deductible contributions are taxed as ordinary income. Any portion of a distribution representing nondeductible contributions is not taxable. $5,500 $6,500 if you will be age 50 or older by the end of 2014 No The portion of a distribution representing contributions is never taxable. Investment earnings and gains are not taxable if you are over age 59 1/2 and the distribution is taken 6 or more years after you begin contributing. What are the penalties for early distributions? Distributions taken before you are age 59 1/2 are subject to a 10% penalty. Investment earnings and gains are subject to a 10% penalty if distributed before age 59 1/2. 1 Compensation for purposes of an IRA includes wages, salaries, tips, professional fees, bonuses, other amounts received for providing personal services, commissions, self-employment income, alimony, separate maintenance payments, and nontaxable combat pay. Compensation does not include earnings and profits from property, interest and dividend income, pension or annuity income, deferred compensation, and income from a partnership for which you do not provide services that are a material income-producing factor. Note that self-employment compensation should be reduced by the total of (1) the deduction for contributions made on your behalf to retirement plans, and (2) the deduction allowed for one-half of your self-employment taxes. Also, you must add back any self-employed health insurance deduction you used in figuring the amount to enter on Schedule SE, line 3. 2 The amount you can contribute is reduced if your modified adjusted gross income is at least $181,000 but less than $191,000 (filing status: married filing jointly or qualifying widower), more than zero but less than $10,000 (filing status: married filing separately and you lived with your spouse at any time during the year), or at least $114,000 but less than $129,000 (filing status: single, head of household, or married filing separately and you did not live with your spouse at any time during the year). 4

5 True Vine Investments Originally Published in September Updated in March 2014 to reflect 2014 IRS numbers. Understanding Individual Retirement Accounts (IRAs) Part 1: IRA Basics 3 Modified adjusted gross incomes (MAGI) greater than these amounts are subject to phaseout ranges. If your MAGI is in the phaseout range you will be eligible for gradually reduced deductions. If you are not covered by an employer retirement plan, but your spouse is, the phaseout range is $181,000 to $191,000 (married filing jointly status) or $0 to $10,000 (married filing separately filing status and you lived with your spouse at any time during the year). If you are employer retirement plan, the phaseout range is $60,000 to $70,000 (single or head of household filing status), $96,000 to $116,000 (married filing jointly or qualified widower filing status), $0 to $10,000 (married filing separately filing status and you lived with your spouse at any time during the year). You are entitled to the full deduction if your filing status is married filing separately and you did not live with your spouse at any time during the year. 4 If your tax status is married filing separately and you did not live with your spouse at any time during the year, your filing status is considered Single for this purpose. 5