an investment opportunity that will never pay a penny of taxes on the growth no matter

how big it gets? Sound too good to be true?

No, we're not talking about some off-shore account in the Cayman islands. This is the

amazing tax shelter of the IRA - a government-created program designed to incentivize you to save

more for your future self.

In 1974, Congress wanted a way to incentivize the country to start saving for their own

retirement, and rely less on government programs or company pensions. Their result was the

creation of the first IRA.

The “I” stands for “Individual”, meaning you don't get to co-own an IRA with someone

else, and it's not dependent on a company offering it to you, like a 401(k). The “R”

stands for retirement, meaning you promise not to withdraw the money until you reach

a certain age. And the “A” can either mean “account” or “arrangement” according

to the IRS. Contrary to popular belief, an IRA isn't an “investment” itself with

a set interest rate or statistics. It's a holding cell for your investment of choice.

An Individual Retirement “Account” can be set up at nearly any bank or investment

company, and can hold investments like mutual funds, stocks or ETFs. But an IRA doesn't

have be an “account”. “Individual Retirement Arrangements” allow you to apply the same

tax-benefits to an investment like a piece of land or a small business. Some folks have

even used this “arrangement” to tax-shelter dairy cows, a car wash and a habanero pepper

farm! As long as you play by the rules, you can get pretty creative about what you choose

to invest in.

IRA's can be broken down to two primary styles; “Traditional” and “Roth”.

The Traditional IRA is the O.G. IRA. When you're going “Traditional”, you're

allowed to save up to $6,000 dollars a year, or $7,000 dollars if you're over age 50.

And as long as you meet the criteria, any money you save into a Traditional IRA is tax-deductible.

Translation: The more you save, the less taxes you'll owe this year!

And since you're paying less taxes, you have more money to…potentially invest in

your IRA! Essentially, it helps you boost up the amount you save every year. As the

years go by and your account grows, you don't have to report the growth on your taxes. But

when retirement arrives and it's time to pull to the money out, the amount you withdraw

gets taxed as ordinary income.

If you're a freelancer or own a small business, you qualify for some special variations of

the Traditional IRA; the first is the SEP IRA. SEP stands for Simplified Employee Pension,

and can be ideal for self-employed people. The SEP will allow you to raise your $6,000

dollar funding limit to the lesser of $56,000 dollars or 25% of your compensation. That's

a HUGE potential tax deduction each year! But beware, if you have any employees, you'll

probably have to fund their IRA's at the same rate as your own.

And if you work for or own a small business, the SIMPLE IRA is kind of like a Traditional

IRA blended with a 401(k). Available to companies with 100 employees or less, the $6,000 dollar

funding limit is raised to $13,000 dollars and offers a saving-match incentive to workers,

usually a 3% matching contribution. So whether you own or work for the small business, the

SEP and SIMPLE can help you level up a basic Traditional IRA

Then there's the Roth IRA, the cooler, younger brother of the Traditional IRA. Making its

debut in the 1990's, and named after Senator Bill Roth, the Roth IRA flips the tax benefit.

Instead of getting a tax deduction on the income you put in now, the capital gains,

interest, and growth can be withdrawn tax-free in your golden years — with no limit! This

is super attractive to younger investors, since their investments can rack up so much

compound-growth over their lifetime, there's a potential boatload of taxes they can avoid.

Let's say you started maxing out your Roth IRA at $6,000 dollars a year every year starting

at age 25. And let's imagine that money gets invested in index funds that grow at

average rate of 8% per year. If you did just that until you reached 65, you'd have around

$1.67 Million dollars.

Under ordinary circumstances, whenever you profit from an investment, you need to pay

taxes. But thanks to your “arrangement” with the government, your Roth IRA hooks you

up big time. In our simplified example, your “gains” account for $1.43 of your $1.67

million dollars. And assuming you owed a “15% capital gains tax” on those gains, you'd

normally be on the hook for over $214,000 dollars in taxes. But thanks to the Roth,

that number is $0!

A couple important things to keep in mind when investing through an IRA. First, you

can't touch the money until age 59 ½, or you'll with get hit with taxes AND a 10%

early withdrawal penalty. Though there are a few exceptions to this rule, like paying

for college or buying a home. And contributions or deductions might be limited or eliminated

if you and/or your spouse aren't working or have a 401(k) or other retirement plan

through your job. And even non-working spouses can save into their IRA if they choose.

So which IRA is right for you? Luckily, you don't have to limit yourself to only one

- many people have multiple IRAs—as long as the total investment doesn't exceed your

yearly cap. The factors that might make a Roth, Traditional, SEP or SIMPLE IRA a good

fit are unique to you - your age, your income, your goals.

Speaking with a tax professional and a financial planner about your situation will always be

a safe bet when deciding which IRA to house your investments of choice. They can help

you make sure you play by all the rules of the “arrangement” and don't overlook

anything.

But one thing's for sure - the advantages of saving into an IRA early and often are

truly too good to pass up.

And that's our two cents!

Thanks to our patrons for keeping Two Cents financially healthy.

Click the link in the description if you'd like to support us on Patreon.

Do you have any other questions about how IRA's work?

Ask us in the comments.