What Is an IRA?
An individual retirement account (IRA) can help you save for retirement and save on taxes. There are two primary kinds of IRAs:
● A traditional IRA gives you a tax break when you put money into it, if you meet certain requirements.
● A Roth IRA gives you tax-free withdrawals when you take your money out. You can only contribute to a Roth IRA if your income is below a specific limit.
The type of IRA that’s right for you depends on your circumstances, and it may change as your life and career progress.
The sooner you begin saving for retirement, the more time your money has to grow, putting you in a better position to enjoy a comfortable retirement of 20 to 30 years or more. An IRA can help you build a retirement savings habit.
If you’re already contributing to an employer-sponsored retirement account, such as a 401(k), an IRA can supplement your savings. If you don’t have access to an employer-sponsored plan—because you’re self-employed or a stay-at-home spouse—an IRA grants you access to potential tax savings. If you’ve changed jobs or held several jobs, an IRA is a convenient way to keep your retirement savings in one place. If you have access to an employer-sponsored retirement plan, you may not be able to deduct your traditional IRA contributions from your taxes, depending on your income.
The Difference Between an IRA and a 401(k)
An IRA is a tax-advantaged retirement account. Unlike a 401(k) plan, the other common retirement savings vehicle, an IRA doesn’t require participation from an employer. You can simply open an IRA on your own at any time. Here are five important details about IRAs:
1. IRAs come in two basic types: traditional IRA or Roth IRA. Both offer potential tax savings designed to boost your retirement savings. The one that’s right for you depends on your specific circumstances.
2. IRAs are subject to contribution caps that are updated annually by the IRS. You can find the current year’s limits at IRS.gov.
3. For contributions to a Roth IRA, there are income-based caps. If you earn more than the cap, you can’t contribute to a Roth IRA.
4. If you or your spouse has access to a 401(k) or another employer-sponsored plan, then you can still contribute to an IRA, but your tax deductions could be reduced if you make more than $65,000 as an individual or $104,000 as a couple filing jointly, so it is important that you review the rules set by the IRS. Even if you work for a small company or only work part-time, you may have access to an employer-sponsored plan. Check with your employer to be sure.
5. You can open an IRA at a bank, credit union, life insurance company, mutual fund company or brokerage firm.
Key Facts About Traditional IRAs
The basic premise of a traditional IRA is to minimize taxes while you’re working and instead pay them in retirement, when you may be in a lower tax bracket. Here’s how it works:
If you have earned income, you are eligible to open a traditional IRA. Not all income counts as earned, though. For example, unemployment benefits, dividends and interest, alimony and child support don’t count as earned income.
You can contribute up to the limit that applies to you. In 2020, combined annual contributions to all of your traditional and Roth IRAs cannot exceed $6,000 if you’re under age 50, or $7,000 if you’re age 50 or older. If your annual earned income is lower than the contribution limit, then your personal contribution limit is equal to your annual income.
You can deduct the money you contribute to your IRA from your taxes in certain cases. The amount you can deduct depends on:
● Your modified adjusted gross income (MAGI)
● Whether you (or your spouse, if you’re married) have access to an employer-sponsored retirement plan
● Your filing status (single, married filing jointly or married filing separately)
Deducting money from your taxable income saves you money today, and earnings in a traditional IRA grow tax-free.
Once you’re in retirement—or as early as age 59½—you can take withdrawals, and you pay income taxes on those withdrawals you haven’t already paid taxes on. If you withdraw any funds before age 59½, you may owe a 10% early withdrawal penalty in addition to the tax. Learn about the exceptions that aren’t subject to the early withdrawal penalty by visiting this IRS site.
You don’t have to withdraw from your traditional IRA at 59½. In fact, if you’re still earning income, you may want to continue making contributions. But at age 72, you must begin taking required minimum distributions annually.
Key Facts About Roth IRAs
Unlike a traditional IRA, a Roth IRA lets you contribute after-tax money now, then withdraw your earnings tax-free in retirement. But that’s not the only difference.
You can only contribute to a Roth IRA if your MAGI falls below certain limits, which for 2020 are the following:
Single filers who earn:
● Less than $124,000 can contribute up to the full contribution limit
● Between $124,000 and $139,000 can make partial contributions
● $139,000 or more can’t contribute to a Roth IRA
Married couples filing jointly who earn:
● Less than $196,000 can contribute up to the full contribution limit
● Between $196,000 and $206,000 can make partial contributions
● $206,000 or more can’t contribute to a Roth IRA
Because you contribute after-tax dollars to a Roth IRA, you don’t deduct contributions from your taxable income and lower this year’s tax bill. Instead, you realize tax savings when you withdraw funds tax-free during retirement, as long as you’ve held the account for at least five years and are at least 59½ years old.
In some instances, you can withdraw money tax-free from a Roth IRA before you’ve reached age 59½, if you’ve held the account for at least five years and use the money for a qualified purpose, such as paying for your first home. What you use the money for must meet specific criteria; otherwise, you’ll owe a 10% tax penalty for withdrawing earnings.
A Roth IRA is appealing if you expect to be in a higher tax bracket when you retire than you are now or if you plan to leave money to your heirs. Roth IRAs don’t have minimum distribution requirements, so you could pass on the entire account balance. If you leave the account to someone who isn’t your spouse, the recipient will have to empty the account within 10 years.
Other Types of IRAs
A handful of other IRA types and strategies may be useful to you:
A SEP IRA is a traditional IRA geared to small businesses or self-employed people. Contributions can far exceed the typical annual limit—up to $57,000 or 25% of the beneficiary’s compensation (whichever is less) in 2020. If you are an employer and you open a SEP IRA for yourself, you must also open one for each eligible employee. Employers must also contribute the same percentage of compensation to employees as they contribute for themselves, though that percentage can change from year to year. Employees cannot contribute.
Like a SEP IRA, a SIMPLE IRA is a traditional IRA designed to give small businesses with 100 or fewer employees an easy way to set up retirement plans for themselves and their employees. But there are several key differences. A SIMPLE IRA allows employees to contribute to their own accounts. (The maximum employee contribution in 2020 is $13,500.) Employers can either match employee contributions up to 3% of compensation or contribute a fixed 2% of compensation every year—whether or not the employee contributes. Workers age 50 or older can make catch-up contributions of $3,000, bringing the yearly cap to $16,500.
The term rollover IRA refers to any IRA—Roth or traditional—that’s funded with assets moved (“rolled over”) from a workplace retirement plan, like a 401(k). You might take this step when you switch jobs, rather than leaving the funds in your old employer’s plan. Doing so preserves your retirement savings, allows the assets to continue to grow and maintains tax advantages. It also potentially makes your money easier to manage, because it’s in an account that’s not tied to your job. Your IRA provider can fill you in on exactly how to arrange the rollover to avoid tax consequences.
Like a rollover IRA, a spousal IRA is not a special account type; it’s a strategy. You generally need to earn income from a job or self-employment to contribute to an IRA. A spousal IRA is the exception. Under an IRS rule for married couples filing jointly, a working spouse can contribute part of their earned income to an IRA for a nonworking spouse. This spousal IRA can be either a traditional or a Roth, and the same deductibility and contribution limits still apply for each.
An IRA CD is available with similar terms as a traditional or Roth IRA. Rather than investing your contributions in stocks or bonds, you put your money into an interest-earning certificate of deposit, or CD. You can choose the maturity term—which could range from three months to five years—that’s right for your goals, and at the end of the term, you have a 10-day period to decide what to do next with your money. If you’re happy with the investment, the IRA CD renews automatically at the end of the 10 days.
How to Make the Most of an IRA
● Choose the right IRA for you. Both traditional and Roth IRAs offer tax advantages. A key factor to consider is the tax rate that applies to your income now and what it may be in the future. You may want to talk to a financial advisor or your tax professional to decide whether it’s better to get the tax break now or later.
● Check in on your choice regularly. As your tax status and income level change, check in to see if you’re better off with a different type of IRA. A big promotion, a marriage, a new home or other life changes could affect what’s best for you.
● Invest in the right assets. Your risk tolerance and time horizon should determine how you invest the assets in your IRA. Generally, the longer you have until retirement, the greater the proportion of stocks, and stock mutual funds, you’ll want to hold.
● Max out your contributions, if you can. The more you put into your IRA, the more you’ll get out of it. That’s especially true early in your career, when your investments have a long time to benefit from the power of compound interest.
● Take advantage of catch-up contributions. When you turn 50, your IRA contribution limit increases. For traditional and Roth IRAs, you can contribute an extra $1,000 annually, bringing your total possible yearly contribution to $7,000. That’s an opportunity to supercharge your savings, and you should take it if you can.
Param Anand Singh writes about money, investing, art, and culture from his home in Henderson, New York.
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This article is part of Vivid Crest Bank ’s Personal Finance Series: Level 101. View all topics in the series here.