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Traditional IRAs

Introduction to traditional IRA's (Individual Retirement Accounts). Created by Sal Khan.

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Video transcript

What I want to do in this video is talk a little bit about traditional IRAs. IRA stands for Individual Retirement Account. Individual Retirement Account. The focus on this video is the traditional IRA. You'll hear of other types of IRAs, especially Roth IRA and SEP IRAs. This is only on Traditional. The just of all of them, is really it's the governments way of encouraging you to save for your retirement. They all have slightly different details, so I'm just going to focus on the traditional right now. Let's say we are in year 0. That's right now. Instead of year 0, let me write "right now." You have 2 options. You could take advantage of the traditional IRA. This is the IRA scenario. This is the no IRA scenario. Now, an IRA allows you to put up to a certain amount of your income aside. Depending on your age and what year it is, that amount will change. In 2010 that number is $5,000 if you are under the age of 50. For under 50. It's $6,000 ... This is for an individual, not for a family. It's $6,000 if you're over the age of 50. Over age of 50. I guess the rational was probably, "Gee, if you're over the age of 50," "you better save even more for your retirement," "which might only be 10 or 15 years away." They gave a little bit more lead way for over the age of 50. Let's say we're under the age of 50 and we take full advantage of this IRA. We set aside $5,000. $5,000. Here we set aside nothing. Set aside nothing. In the very short term, the advantage is that this $5,000 of our income will not be taxed. Let's say that my tax bracket ... Let's say that I'm in a 32% tax bracket. 32% tax bracket. Let me write that on the side. It will apply to both scenarios. 32% tax bracket today. I'm making some good money. Tax bracket today. On the $5,000 only, I'm only talking about the taxes on the $5,000. You're going to have to pay taxes above and beyond that on the rest of your income. Today, I'm going to pay 0 taxes on that $5,000. 0 taxes on the $5,000. If I don't set aside that $5,000 into an IRA, then I will have to pay taxes on that $5,000. I'm going to have to pay $5,000 x 32%. Which is equal to what? I'll just get a calculator out. You get 5,000 x .32 = $1,600 in taxes, I'm going to pay $1,600 in taxes today. In the year that I actually made that $5,000. I can't set aside $5,000 if I made less than $5,000. It's always the lower of your income or these IRA limits. Of course, you're going to pay, even in this situation. Let's say you made $100,000. When you put the $5,000 aside, you're still going to have to pay taxes on $95,000. In this situation, where you didn't put the $5,000 aside, you're going to have to pay taxes on $100,000. You're going to have to pay taxes on the extra $5,000, which is $1,600. Let's say in either situation, with that $5,000, you want to buy and sell some securities or some investments. Let's say right after you put in the IRA account … Now everything is sitting in our IRA account. All of our transactions are sitting in this special IRA account right here, where we can actually buy and sell investments and trade them. But, we can't cash them in and turn them into cash and then spend it on a new car or something like that. If we did do that, before the age of 59 1/2, we would have to pay a penalty. Let me write that down. You might immediately say, "Hey gee, this is a good idea." "Why doesn't everyone always do it?" The answer is, if I pull it out before 59 1/2, I pay a penalty. Let me write this down, because that's important to keep in mind. Pay penalty and taxes if withdrawn before 59 1/2. Once again, this is the Traditional IRA. The Roth IRA, for example, is a little bit more flexible on the actual principle amount that you put into the account. We're just dealing with Traditional. This is an important thing to keep in mind. This is kind of the tradeoff that you're giving. The government is saying, "Hey, I'm giving you an incentive to put this aside" "and I really want to make sure that you leave this aside" "until you are ready to retire." "You don't get tempted, when you see a nice sports car," "to cash in your IRA and use it," "because you're going to have to pay a penalty." As long as you don't actually withdraw it and turn it into cash, you can actually buy and sell securities within that IRA. Let's say, as soon as you put that $5,000, you buy $5,000 of stock A. Here, we don't have $5,000 anymore. We only have $3,400 of our original amount, so we buy $3,400 of stock A. Let's say, I don't know, 10 years in the future. Let's say in 10 years ... This is going to be in either situation. In 10 years, let's say that stock A has doubled, and you sell it. Now, you sell it. You have $10,000 here. You have $10,000 from sale of A. It's doubled. Here's it's doubled, but you only have $3,400 of stock A. Now, that $3,400 is worth $6,800. You have $6,800 from sale of A. Let's say you want to put that into another stock. Let's say you put that all into stock B. I'm painting a very rosy picture. You can't always insure that stocks will double. You buy $10,0000 in this situation. $10,000 of B. I'll hold off there. You buy $10,000 of B. Here you might say, "Oh, I'm going to buy $6,800 of B. Because you are not operating within an IRA account, you're going to have to pay taxes on the capital gains from this right here. Capital gains are gains made from capital investments. In this case the capital investment is investing in stocks. Since you owned your stock for more that 1 year, you at least will only have to pay long-term capital gains, which tends to be lower than short-term capital gains. In this situation you made a $3,400 profit. Not $340,000. You made $3,400 profit. You are going to have to pay 15% capital gains. x 15%. Let's get the calculator out again. 3,400 x .15 = $510. You're going to have to pay $510. This is $510. You take your $6,800, pay $510 to the IRS. You are going to be left with $6,290. Remember, the reason why you have to pay taxes is this is not operating inside of an IRA. Here you are operating inside of an IRA, so you don't have to pay taxes. Let's say you invest in stock B and then over the next 10 years, stock B also doubles. Stock ... so this is 10 years. Stock B is now worth $20,000 and you sell it. From sell of B. Once again, it's sitting inside of your IRA, so you don't have to pay any capital gains on it. In this situation, you use that $6,290 to also invest in stock B, and after 10 years stock B doubles. It is now … What is that? $12,580. Once again, it's sitting outside of your IRA. You have to pay 15% capital gains. You had a $6,290 gain. $6,290 gain x 15%. Let's see what that is. I'll get the calculator. Where's my calculator? There is it. You have $6,290 x 15%. That's equal to 943. Let me take that from my 12,580. 12,580 - 943.5 is equal to ... I have $11,636. I now have $11,636. Let's say 20 years have past. We are now over the age of 59 1/2. We can now withdraw from our IRA. Of course, this situation, this is cash that we have. We can do anything with it. Maybe we're now over 60 years old. This could be used for our retirement, for our everyday expenses. This money that was sitting in IRA, now that we're over the age of 60, we're over 60 now, or over 59 1/2 if you want to be particular. Now that we're over 60 we can withdraw the IRA without paying any penalty, but we will have to pay taxes. We're going to withdraw. No penalties. We will have to pay taxes, but the huge advantage here is, once we're over 60, we're probably earning less money. The actual tax bracket that we're in is probably going to be lower. Let's say we're in a 25% tax bracket. Remember, when we first made that $5,000 we were in a 32% tax bracket, because we were this young gun at the peak of his or her career, making a lot of money. Now, we're making less money. We're trying to live off of our savings, so we have to pay 25% income tax on it. If we pay 25% on $20,000 ... Remember, now we're actually withdrawing it. We're actually putting it in our checking account so we can spend it for living or whatever we want to do with it. 25% of $20,00 is equal to $5,000 in taxes. We will be left with $15,000 to do anything that we want with it. Compare this. This is $15,000 verses $11,636. Everything that we did was completely identical, except for, over here we took the $5,000 and invested within an IRA. Here, we took the $5,000, we had to pay taxes on it. Then, we invested it in the exact same way. We actually made very good stock investments in both situations and we ended up with a significant less amount of money. This is $15,000 verses $11,000. That's almost … What is that? 30 something % difference in the total amount of money you have. Not only that, but this tax we had to pay, we don't have to pay this … this is only in situations where you have a 25% tax rate. When you're retired you might even have a lower tax rate than that and it's deferred a good bit. The real thing to think about is just, 20 years in the future you're sitting on $15,000 verses if you didn't participate it in the IRA you're sitting on only a little over $11,500. Of course, the main trade off here is that in the IRA situation, you really couldn't touch your money. If you had an emergency and you had to withdraw the money, you would have had to pay penalties on it.