If you’ve ever dipped your toes into retirement planning and investing, you’ve surely come across the Individual Retirement Account, more commonly known as the IRA. If you’re unsure exactly what it is, it’s an investment account that allows you to deduct contributions from your taxable income in exchange for tax-deferred growth.
Barring any non-qualifying withdrawals, you won’t owe taxes throughout the year on any profits you earn from dividends, interest, or capital gains made within the IRA. Finally, in retirement, you pay ordinary income taxes on your withdrawals that have grown without the usual tax drag that accompanies standard brokerage accounts.
Alternatively, there’s the Roth variant of the IRA, and it works opposite from a tax standpoint. Instead, you get taxes out of the way immediately and then enjoy tax-free withdrawals in retirement – provided you follow Roth withdrawal rules.
Sounds great, right?
The simple fact remains that despite all of the potential benefits, an IRA may simply not be the best route for you. Let’s delve into some of the reasons an IRA may – or may not – be a potential route for your savings.
Are You Comfortable With Investing?
Opening an IRA entails purchasing assets you hope will provide a return, either as a capital gain, a dividend, or interest. As we all know, investing is risky, and you could end up with less than what you started. However, if you have a hefty risk appetite, you may find the prospect of tax-deferred growth on top of a tax deduction quite appealing.
Let’s imagine that you’re a single firefighter with a gross income of $62,000. You contribute $7,000 to your IRA and deduct it from your taxable income. Your deduction, combined with 2024’s $14,600 standard deduction, actually drops you down from the 22% tax bracket to the 12% tax bracket, potentially freeing up an additional $865 to do with as you please – like investing further.
Tax Breakdown for Single Firefighter with $62,000 Income
| Portion of Income | Tax Rate | Tax Amount |
|---|---|---|
| $0 to $11,600 | 10% | $1,160 |
| $11,601 to $47,150 | 12% | $4,266 |
| $47,151 to $47,400 | 22% | $55 |
| Total Tax | $5,481 | |
| Portion of Income | Tax Rate | Tax Amount |
|---|---|---|
| $0 to $11,600 | 10% | $1,160 |
| $11,601 to $40,400 | 12% | $3,456 |
| Total Tax | $4,616 | |
$865, growing at 10% a year (the historical average S&P 500 growth rate), would come out to around $5,819 in 20 years. That may not seem like a lot, but if you consistently apply a tax-savvy approach to your investments, year after year, those yearly savings could snowball on their own. Also, keep in mind that the S&P 500 isn’t guaranteed to give you 10% a year or anything at all. Again, there are no guarantees or promises when investing.
Do you have high-interest debt to take care of first?
The average credit card interest rate in 2024 is around 21.47%, which can significantly impact your financial health if not managed properly. Moreover, the average credit card debt per household in the U.S. is at a record high of $1.129 trillion as of the fourth quarter of 2023, with nearly half of Americans carrying debt from month to month.
Chances are that if you’re reading this, you have high-interest credit card debt, and you may be struggling to pay it off. Before you even consider opening an IRA, you need to pay off that debt first. What kind of snowball would you rather have – a 10% average S&P 500 growth or 21.47% debt?
To compare our 20-year growth of your tax savings at 10%, $865 of credit card debt at 21.47% could balloon to approximately… $42,305. That’s about a $36,486 difference.
| Scenario | Initial Amount | Annual Growth Rate | Amount After 20 Years |
|---|---|---|---|
| Investment Savings | $865 | 10% | $5,819 |
| Credit Card Debt | $865 | 21.47% | $42,305 |
| Difference | $36,486 | ||
Bottom line: you may want to pay down that debt as fast as possible, as it will most likely significantly outpace your investment returns.
Do you qualify for a tax deduction? (Traditional IRAs Only)
Without the tax deduction, your contributions to a traditional IRA won’t reduce your current taxable income. This means you won’t see immediate tax savings that could enable you to invest even more money. Additionally, you’re putting limitations on the access and withdrawal of your funds. Even if you contribute non-deductible funds to your IRA, you likely won’t be able to touch the growth of those funds until you reach 59½ without penalties. Is it worth it?
Furthermore, with a traditional IRA, you’ll be forced to take Required Minimum Distributions (RMDs) once you reach a certain age. Essentially, the IRA comes with certain restrictions that, when combined with the tax benefits, make it worth it—but with one of those key benefits missing, other investment accounts may be more palatable.
You may not qualify for a tax deduction if your income exceeds certain thresholds. Alternatively, if you qualify for a partial deduction, you may want to go back to the drawing board to determine if the IRA is a right fit after all.
| Filing Status | Income Range for Full Deduction | Income Range for Partial Deduction | No Deduction |
|---|---|---|---|
| Single or Head of Household | Up to $77,000 | $77,001 to $87,000 | Over $87,000 |
| Married Filing Jointly | Up to $123,000 | $123,001 to $143,000 | Over $143,000 |
| Married Filing Separately | N/A | Up to $10,000 | Over $10,000 |
| Non-active Participant Married to an Active Participant (Filing Jointly) | Up to $230,000 | $230,001 to $240,000 | Over $240,000 |
When would you need those funds?
Remember, any funds you contribute to an IRA are essentially locked up for a long time. Yes, there are specific instances when you can remove your funds without incurring a penalty – but that’s not really the point of an IRA. If you anticipate needing access to your funds before retirement, you might want to consider alternatives to a traditional IRA to avoid the consequences of early withdrawals.
Here are a couple of options:
Brokerage Account
It’s completely possible to obtain a significant level of tax efficiency within a brokerage account – ETFs for example – while also obtaining much greater flexibility regarding withdrawals. With the click of a button, your funds can be made available – just remember to pay the tax bill.
529 Plan
If you’re planning for education expenses, a 529 plan could be a better fit. These plans offer tax advantages when the funds are used for qualified education expenses, such as college tuition, fees, and books. Additionally, the earnings grow tax-free, and withdrawals for qualified expenses are also tax-free. So, it’s like an IRA, but for the likely shorter-term horizon of college expenses.
Are other retirement accounts sufficient?
As a firefighter, you more than likely have a pension and possibly even DROP savings. If those savings are enough for your retirement, then you may want to consider simply improving your lifestyle rather than sacrificing a portion of your savings to an unnecessary retirement account. Additionally, it’s worth evaluating if there are any gaps in your retirement plan that other investment accounts could fill, such as a Health Savings Account (HSA) to cover medical expenses.
However, if you don’t feel your pension will be sufficient, and you don’t qualify for Social Security or have 401(K) from another employer or business, perhaps the IRA can provide you the tools necessary to cushion up your savings enough for a successful retirement.
In Conclusion
It’s easy to get caught up in thinking that since you’re a firefighter, your retirement is taken care of for you. You have your pension, right? However, there’s always a chance that your pension plan could face challenges. For example, it might become underfunded, making it difficult to meet its obligations or changes in laws and regulations could impact the benefits you receive. Additionally, life happens, and you could be forced into an early retirement in a manner unrelated to firefighting, putting you at risk of a reduced benefit.
Does that mean you need an IRA?
As we’ve shown, it all depends on your personal situation and risk tolerance. An IRA may help you reach your goals and provide the security you desire, but there may be better strategies for you. In any case, you won’t know until you sit down with a financial professional who can carefully balance the benefits and drawbacks of an IRA and how they pertain to your and your family’s finances.
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