What is an IRA?
An individual retirement account (IRA) is a savings plan that offers specific tax advantages to help you save for retirement. There are several different types of IRAs, including traditional IRAs, Roth IRAs, spousal IRAs, SEP IRAs, SIMPLE IRAs, non-deductible IRAs, and self-directed IRAs.
The main benefit of an IRA is that it allows you to save for retirement on a tax-deferred basis. That means you won’t have to pay taxes on the money you contribute to your IRA until you withdraw it during retirement. This can help you save more for retirement because your money will grow faster than if it were subject to taxation yearly.
Traditionally, IRAs have been invested in stocks, bonds, and mutual funds. However, recent changes in the law now allow for alternative investments such as real estate, private equity, and hedge funds to be held in an IRA. This is a significant change because it opens up a new world of investment opportunities for retirement savers.
What are the benefits of each type of IRA?
The most common type of IRA is the traditional IRA. With a traditional IRA, you can make tax-deductible contributions, and your money will grow tax-deferred until you retire. When you withdraw money from a traditional IRA in retirement, you will pay taxes on the withdrawals.
The second most common type of IRA is the Roth IRA. With a Roth IRA, you make contributions with after-tax dollars (meaning you’ve already paid taxes on the money you’re contributing). This means that when you withdraw money in retirement, you won’t have to pay any taxes. You may have heard of the term “backdoor IRA,” which describes the process of contributing to a Roth IRA when your income exceeds the Roth contribution limits.
Self-directed IRAs are a type of IRA (a traditional or Roth IRA) that gives investors more control over their investments. With a self-directed IRA, you can invest in alternative investments such as real estate, private equity, and hedge funds.
Why do IRAs matter for alternative investors?
Investors typically seek out alternatives for portfolio diversification and the potential for higher returns. For instance, private markets have consistently outperformed public markets over the long term.
However, all capital gains are subject to taxation. This can eat your returns, especially if you’re in a high tax bracket.
One way to avoid this is to invest in alternatives through an IRA. With an IRA, you can invest in alternatives on a tax-deferred basis. That means you won’t have to pay taxes on the capital gains until you retire and start withdrawing money from the account.
This can be a significant advantage because it allows your money to grow faster than it would if it were subject to annual taxation.
IRAs and alternative investments are a natural pair because they’re both long-term investments. That means you won’t need to access the money in your IRA for many years, allowing you to take on more risk in pursuit of higher returns.
Limitations of IRAs
One downside of IRAs is that they have contribution limits. For 2021 and 2022, the contribution limit for traditional and Roth IRAs is $6,000 (or $7,000 if you’re 50 or older).
This can limit high-income earners who want to save more than the contribution limit allows. In this case, you may consider investing in alternatives outside of an IRA.
Another downside of IRAs is that they have required minimum distributions (RMDs). RMDs are the minimum amount you’re required to withdraw from your IRA each year once you reach age 70 1/2. The purpose of RMDs is to ensure that people don’t use their IRAs as tax-deferred savings account for their entire lives.
However, RMDs can burden investors who don’t need the money and would prefer to keep the money invested.
Another downside of IRAs is that they have estate taxes. When you die, your IRA will be included in your taxable estate. Your beneficiaries will have to pay taxes on the distributions they receive from the IRA.
IRAs vs. 401(k)s, 403(b)s, and 457(b)s
401(k)s are employer-sponsored retirement plans. That means your employer offers the plan, and you make contributions through payroll deductions. 401(k)s have higher contribution limits than IRAs (up to $20,500 for workers under 50 in 2022). They also typically offer employer-matching contributions, which can be a significant advantage.
However, 401(k)s are subject to RMDs just like IRAs. And, if you leave your job before you reach age 59 1/2, you’ll likely have to pay a 10% early withdrawal penalty on the money you withdraw from your 401(k).
The main difference between IRAs and 403(b)s is that 403(b)s are employer-sponsored retirement plans for public schools and non-profit organizations’ employees. Other than that, they work the same as 401(k)s. Another type of employer-sponsored retirement plan is the 457(b) plan. 457(b) plans are for state and local government employees (and some non-profit employees).
IRAs vs. Annuities
Annuities are a type of insurance product used for retirement planning. With an annuity, you make one lump-sum payment (or a series of payments), and the insurer agrees to make periodic payments to you for a specified period (typically during retirement).
There are two main types of annuities: fixed annuities and variable annuities. Fixed annuities guarantee a fixed rate of return, while variable annuities offer the potential for higher returns but also come with more risk.
The most significant advantage of an annuity is that it offers a guaranteed income stream in retirement. That can be a valuable benefit, especially if you’re worried about outliving your savings.
The downside of annuities is that they’re often complex products with high fees. They also typically have surrender charges, which means you’ll pay the penalty if you withdraw your money before the specified period.
The Bottom Line
Alternative investors seek long-term capital appreciation and higher return potential through investments such as private equity, real estate, and hedge funds.
While these types of investments are subject to taxation, one way to defer taxes is by investing in them through an IRA. With an IRA, you can make tax-deferred contributions, and your money will grow tax-deferred until you retire. When you withdraw money in retirement, you’ll pay taxes on the withdrawals but not on the money that has grown in the account.
With Gridline, you can quickly and efficiently gain exposure to top-quartile private market alternative investments in your IRA. Gridline’s mission is to open up access to these investments, which have historically been available only to sophisticated family offices and endowments, allowing individuals to invest transparently, efficiently, and at a lower cost.