What Is An IRA: Everything You Need To Know About Individual Retirement Accounts
Though it may seem like a long way off, it’s never a bad idea to save for your retirement. While it’s good to enjoy the fruits of all your hard work in your 20s and 30s, you also shouldn’t forget to set aside some money each year for retirement. That way, by the time you enter your sunset years, you can actually enjoy the sunsets – and hopefully from a beautiful beachfront home.
But there’s more to retirement savings than filling up a piggy bank with some money. Here, we’ll answer one of the most frequently asked questions about the topic: “What is an IRA?”
Understanding The IRA
I R A stands for Individual Retirement Account (or Arrangement) – an investment account/arrangement used for tucking away money for retirement.
Back in 1974, the United States Congress wanted to encourage more people to save money for retirement. Their intention was to have fewer people depending on the government in their later years, and more folks living financially-independent and overall richer lives as seniors. Their solution was to incentivize savings with tax advantages, and thus the IRA was born.
An IRA's purpose is to help you maintain a fund you can draw from in your retirement years. But different types of IRAs come with different types of advantages too. For example, traditional IRAs make it so that the cost of your contribution can be tax-deductible. Meanwhile, a Roth IRA lets you grow and withdraw money from the account tax-free.
The Main Types Of IRAs
Before opening an account, it’s important to know which types of IRAs suit you best. Generally, there are two main kinds of IRAs. Let’s parse the similarities and differences between these two below:
The biggest draw of the traditional IRA is that any money you save into the account is tax-deductible. This means that the more money you put away, the less you have to pay in income tax by the end of the year. However, when you finally decide to make use of that money, the amount you withdraw will be taxed as ordinary income. Just think of it as deferring your tax deductions by several years.
There are limitations to how much you can set aside each year though. With traditional IRAs, you’re allowed to save up to $6,000 per year until you’re 49 years old, and $7,000 from the age of 50 or older.
As for when you can make withdrawals, generally, you can pull out money from a traditional IRA any time. However, you’ll have to cough up a 10 percent penalty and pay for taxes if you choose to do so before age 59 and ½. There are some exceptions to this rule, such as paying for college.
There are two kinds of traditional IRAs, the Simplified Employment Pension (SEP) and the Savings Incentive Match Plan for Employees (SIMPLE) IRA. The SEP-IRA is normally given out to self-employed individuals, such as freelancers. With the SEP-IRA, the funding limit is raised to up to $56,000 a year, or 25 percent of your compensation. The drawback to the SEP-IRA is if you have employees – for every employee under you, you have to fund their IRA at the same rate.
On the other hand, a SIMPLE IRA allows small business owners and their employees to make contributions to the fund. The SIMPLE IRA has a $13,000 funding cap.
In 1997, Senator William Victor Roth, Jr. helped to establish the Taxpayer Relief act of 1997, which brought about the tax-free Roth IRA.
Unlike in a traditional IRA, your contributions aren’t tax-deductible. You also don’t get taxed for taking out your funds or withdrawing in retirement. Essentially, Roth IRAs allow you to grow your money tax-free as well as withdraw your contributions tax-free.
Why pick one over the other? It depends on what you value at the present moment. If you’re hoping to save some money on your yearly tax contributions, a traditional IRA is a way to go. But if you’re hoping to have a tax-free retirement, Roth IRAs might be more suited to you.
Tip: It’s important to note that IRAs are NOT investments in themselves. Instead, think of IRAs as mere safehouses for your investments. An Individual Retirement Account can hold investments like (and gain tax benefits from) mutual funds, stocks, and ETFs, while an Individual Retirement Arrangement can give you tax benefits from properties such as land and businesses.
Other Examples Of IRAs
IRAs are not limited to the tax-advantaged traditional IRA and the tax-free Roth IRA. Here are a few more types of IRAs.
A rollover IRA is simply an account that lets you transfer money from other retirement accounts (such as a 401k) into an Individual Retirement Account. Rollover accounts are beneficial to people who are switching jobs and want to maintain their retirement funds themselves.
Additionally, rolling over funds gives you more options. For example, a 401(k) allows you to hold investments like mutual funds but not bonds and ETFs. So if you want to widen your options, rollover accounts help you achieve that goal and potentially rack up more in future savings.
If you’re married and choose to be a stay-at-home mom or can’t work due to illness/disability, you still have some retirement options. One is the spousal IRA, which allows a working spouse to contribute to an IRA under the name of a non-working spouse. This also works for spouses with very little income.
Also called an SDIRA, a self-directed IRA allows you to hold investments that are not usually allowed for either the traditional IRA or Roth IRAs. Unlike in the latter two, which limit investments to stocks, bonds, ETFs, mutual funds, and certificates of deposits, SDIRAs allow alternative investments such as real estate, private placements, and even precious metals, among others.
Also known as a beneficiary IRA, this is an account opened when a relative or spouse passes away and leaves behind an IRA or employer-sponsored retirement account to a beneficiary. In some cases, beneficiaries may not be able to make additional contributions to the beneficiary account.
The rules for rolling over funds and transferring ownership of the account depend on the inheritor's relationship with the deceased. If your spouse passes away, you can typically roll over their IRA into your own retirement account. However, if your benefactor is not your spouse (i.e. your mother or your father), you may not be allowed to roll over funds. Instead, you must set up a brand new account in order to access the funds.
IRA vs 401(k)
While IRAs and 401(k)s seem like essentially the same thing, there are a few key differences. As its name suggests, an Individual Retirement Accounts is opened and managed by the individual, while a 401(k) is an employer-sponsored pension.
Opening an IRA gives more freedom in terms of the kinds of investments you can put away, but 401(k)s allow you to make significantly larger contributions per year. With a traditional IRA, you're allowed to save up to $6,000 per year before you turn 50, and $7,000 when you're 50 or older. On the other hand, 401(k)s cap the contribution limit at $19,000 per year.
One of the main draws of the 401(k) is the potential for employer matching. This means that your employer can potentially put in the same amount of money you contribute, thus doubling your retirement fund!
How To Open An IRA
Here's everything you need to know about opening an IRA:
Eligibility And Requirements
Age: Before Jan 2020, you couldn't open or contribute to a traditional IRA if you were past the age of 70 1/2. However, today, the restriction has been lifted, meaning you can open and contribute to a traditional IRA at any age. There is also no age limit for opening and contributing to a Roth IRA.
Eligible compensation: You must have taxable compensation to open and contribute to an IRA account. Eligible compensation includes earned income, tips, sales commissions, and net earnings from a business.
Contribution limit: For 2020, you can contribute up to $6,000 if you're below the age of 49, and $7,000 if you're 50 or older.
Contribution deadline: Make sure your IRA contribution meets the April 15 yearly tax filing deadline. Otherwise, you may not be able to get tax deductions on your traditional IRA.
Documents: To open a traditional IRA or a Roth IRA, you may need to submit the following documents: identification (driver's license, passport, etc.), social security number, employer details, and the details of your retirement plan beneficiary.
Where Can I Get An IRA?
An IRA can be opened at most major financial institutions, such as banks, credit unions, mutual fund companies, and brokerage firms. However, different institutions have different rules and conditions for applicants. For example, some banks and credit unions offer a motley of investment options, but others will only be able to offer you a savings account or a certificate of deposit for your retirement plan. While these are great for short-term savings, they might not accrue enough money for a proper retirement plan.
Before settling on a firm or a bank, make sure to shop around and always lead with these three questions in mind:
What is the opening and maintenance fee? Not all financial institutions will allow you to open an account sans opening fees, maintenance fees, and minimum deposits. For example, most mutual fund companies require a minimum investment of about $3,000 to open an account. Always check with your prospective bank or credit union to make sure you're capable of shouldering the upfront fees.
What types of investments can I maintain? As mentioned, not all banks and credit unions offer the same range of investment options. Most banks will allow you to open a savings account or a CD, which are both quite safe yet accrue very little interest. Meanwhile, other institutions will let you invest in mutual funds and ETFs, which may be riskier than other types of investments, but also offer the potential for higher returns.
What is the company's customer service like? Remember that, when shopping for a bank or brokerage to open an IRA with, you're entrusting your investments and savings in these financial institutions. So choose wisely. Always look them up online and ask around for feedback on their service. Better yet, consider financial institutions that have been tried and tested by friends you can trust.
The Do’s And Don'ts Of IRA Investing
Once you've set up your account, keep the following tips in mind to maximize your savings and get the most out of your IRA contribution in the future:
Don't: Earn Less Than You Can Contribute
There are two ways you can become eligible to contribute to a tax-free Roth IRA: having earned income and running your own business. If you're an employee or consider yourself self-employed, you should be mindful not to contribute more than you make in earned income. Earned income is classified as income coming from salaries, tips, bonuses, and professional fees, as well as military differential pay and commissions.
What's not considered earned income? Any money you make from interest, dividends, or capital gains is considered unearned income and cannot be considered as allowable contributions to a Roth IRA.
Do: Be Mindful Of Your Income Limit
It's possible to earn too much income to be eligible for a Roth IRA. As of 2020, single taxpayers and married ones who file separately from their spouses are allowed to make Roth IRA contributions if they earn less than $124,000 a year. If you're married and filing jointly, you can contribute to a Roth IRA if you earn less than $196,000.
Note that by income, we mean your modified adjusted gross income or MAGI. Your MAGI may be significantly different from your gross income, as it excludes certain factors from the computation such as foreign earnings and contributions to a traditional IRA.
Don't: Forget To Contribute For Your Spouse
If you're legally married and have a non-working spouse, they can establish a spousal IRA. As mentioned above in the list of different types of IRAs available, a spousal IRA allows a working spouse to make contributions to their non-working spouse's account. This way, you're able to set aside a retirement fund for both you and your partner, allowing you to enjoy a richer and happier retirement together.
Do: Work With A Reliable Custodian
This is especially true if you're self-employed and/or new to the world of investments and retirement plans. You want to work with someone who is knowledgeable enough to guide you through the process, can walk you through the IRA rules, and who can be there to answer any questions you have about saving up for retirement.
Don't: Assume You Don't Need An IRA Because You Already Have A 401(k)
Not only are you allowed to have both a 401(k) and an IRA at the same time, you're actually encouraged to do so. These two accounts offer a different set of benefits – 401(k)s have larger contribution limits and employer matching possibilities, while IRAs allow more investment options, from stocks to bonds to ETFs. Contributing to two accounts allows you to enjoy the best of both worlds.
Do: Keep An Organized IRA
Whether you've got one IRA or several, it's important to keep all the vital information organized. After all, this is the retirement money we're talking about.
Take stock of everything that has to do with your IRAs, from your income to employer-sponsored accounts to life insurance and other existing investments. You can use a spreadsheet or portfolio management software to consolidate all your financial information into one master file that you can easily access when necessary.
Is An IRA Worth It?
It may not seem worth the effort now, but opening a retirement plan that's separate from your employer-sponsored 401(k) opens up greater possibilities in terms of the kinds of savings you can have in retirement. Now, it's just a matter of weighing your options and deciding on the best retirement plan for you.
If you want to learn more about the traditional IRA, Roth IRAs, and even employer-sponsored accounts like 401(k)s, Wesley Mortgage, LLC can help! Contact us today for an expert consultation.