by Kyle Buffo
I talked with a financial manager of a mid-sized family owned business that was going through an estate transition. During the process, she came across some IRA’s owned by the family. Shocked by the low returns of the IRA over the many years owned, she mentioned this to the IRA owner. Since the IRA owner was one of the lead decision makers for a family estate worth well into 8 figures, the financial manger thought there must have been some logic for holding these funds in these particular low-earning investments.
When approached about this topic, the IRA owner replied with a nonchalance, “IRA’s just don’t make much money,” especially in a low rate environment. She was correct for that IRA investment, but this common misconception and other retirement fallacies can cause outsized damage to the growth of your retirement portfolio.
The reason the previously mentioned IRA accounts weren’t making “much money” is because of what they were invested in: conservative, low risk, short-term bank CD’s (which pay less than a measly 1%). CD’s are not necessarily bad, but the IRA owner was under the false impression that IRA’s are a specific investment itself. Many people think “investing in an IRA” is a thing. This statement can be very misleading and cause mass confusion.
IRA is a type of an account, just like you can have an Individual savings account or a Joint checking account. IRA (Individual Retirement Account) is a type of account that receives special tax treatment. Just like a Joint account can have investment in CD’s, stocks, bonds or cash; so can an IRA.
I mentioned in a previous article that IRA’s are even more crucial to musicians due to their increased reliance on IRA’s for their personal finances. Before making key decision about your retirement savings, make sure you have a full understanding about how IRA’s work and how investing works. If you aren’t 100% comfortable, find help from a financial planner that you know you can trust (the bottom of this article has the best resources for finding a financial planner that will work for you).
Let’s start with a very basic example. We will assume Mr. Pianist has $5,000 that he wants to save for his retirement years. He invests this money in Investment A (think of it as anything, stocks, bonds, mutual funds, ETF’s, real estate, CD’s, or even cash). There are 2 main ways to make money on the investment – dividends, or money paid out while holding the investment; and capital gains which is the difference between what you bought it for vs what you sold it for.
Assume Mr. Pianist earns dividends every year of $250 or 5% on Investment A, and hopefully he is reinvesting those dividends. If you are familiar with the wonders of compound interest, you’ll know that the reinvestment will lead to exponential growth, and each year the investment will earn even more.
Mr. Pianist can also realize a gain or loss when he sells Investment A, the difference in the value from purchase to sale. If he can sell Investment A for $6,000 he just made another $1,000 in addition to the dividends he earned.
What the IRA’s do
Savings for retirement is hard – people just don’t do it. That’s why the government incentivizes us the best way they know how: through tax incentives. IRA’s came about in the mid 1970’s as a way to encourage saving. There are many rules with IRA’s (again, talk to your financial professional), but the current general gist of these accounts is that gains made on funds here are tax-free IF they are left untouched until a certain age (currently, 59.5). If funds are pulled from the accounts before this age, they are taxed at your current effective tax rate plus a penalty.
If Mr. Pianist was taxed on the dividends (15%) he received each year, after 30 years his $5,000 investment would grow to $22,236 (assuming 6% return every year). However, if Mr. Pianist could avoid that tax by having the investment in an IRA account, the investment would grow to $28,717.
This is just a partial explanation of the tax rules related to IRA’s but this example shows how tax strategies can have major consequences on your personal finances. There are many variations on IRA’s, including Roth IRA’s and SEP IRA’s. In fact, while less familiar to typical consumers, SEP IRA’s may have even better benefits for most musicians. Musicians must utilize proper tax planning strategies in managing their current business but also in retirement planning.
Know the Investment Options
Going back to my first example of the IRA investor not understanding that an IRA is a type of account, not an actual investment, we can see another example of how not understanding IRA rules can wreak havoc on your retirement portfolio. The IRA investor had other individual investment accounts that were invested appropriately for her risk profile and long term plans. These investments were returning well over 5% during the same time their IRA was making less than 1%.
If the money in the IRA was invested in a way that lined up with the IRA owner’s preferences (like their other investments making 5%), instead of the extremely low yielding CD’s (1%), over 10 years they would have received an additional $52,427 for every $100,000 invested.
Investing with Confidence
I think the examples show that making a mistake on your IRA’s can have major financial consequences. They should also show the sheer power IRA’s have on making your investments grow more efficiently. Don’t let the fear of a mistake stop you from leveraging the benefits of IRA’s, as they are crucial to most musicians’ long term financial goals. Spend the time to really be comfortable with tax strategies and investment options and how they fit into your overall plan, or find appropriate help with creating a strategy.
Have specific questions on IRA’s or retirement? Post a comment below to suggest a topic to be covered in a future post.