What is an IRA? Here's what you need to know.
Individual Retirement Accounts (IRAs) are a popular way to save for retirement. These accounts offer individuals the opportunity to invest their money and earn returns that can help grow their savings over time.
IRAs come in different types, including traditional IRAs, Roth IRAs, and SEP IRAs. Each type has its own unique rules and benefits, but all IRAs share a common goal: to provide individuals with a way to save for their future and enjoy a comfortable retirement.
What is an Individual Retirement Account (IRA)?
An individual retirement account (IRA) is a long-term savings account that offers tax advantages. Like a 401(k) account, an IRA is designed to persuade people to save for retirement. But unlike a 401(k), anyone who has earned income can open an IRA and enjoy the tax benefits (reminder: a 401(k) account is only offered through employers and cannot be obtained by an individual. Learn more about 401(k)s. You can open an IRA account through most banks, credit unions, investment companies, online brokerages, or personal brokers.
Anyone with earned income can open and contribute to an IRA, including people who have a 401(k) plan through an employer.
Types of IRAs
Like a corporate-sponsored Traditional 401(k), Traditional IRA contributions are made with pre-tax dollars, meaning you get a tax break upfront. However, because of this type of setup, you get taxed upon withdrawing your money from the account at the current tax rate. In other words, you benefit now (by using pre-tax income) and get taxed later (when you withdraw your money).
If your employer doesn’t offer a retirement plan, your traditional IRA contributions are fully tax deductible. But if you (or your spouse, if you’re married) have a retirement plan through work, such as a 401(k), your modified adjusted gross income (MAGI) determines whether and how much of your traditional IRA contributions can be deducted.
Like a Roth 401(k), Roth IRAs are accounts that you contribute to with post-tax income, but you can withdraw tax-free when you retire. In other words, you get taxed now (by using post-tax income) and get the benefit later (when you pull your money out at retirement tax-free). But unlike a Roth 401(k), anyone with an income can contribute.
With traditional IRAs, you get a tax break now and pay taxes later. With Roth IRAs, you pay taxes now and get a tax break later.
A Simplified Employee Pension (SEP) IRA allows self-employed individuals like contractors, freelancers, and small-business owners, to set aside money in retirement accounts for themselves and their employees. A SEP does not have the start-up and operating costs of a conventional retirement plan and allows for a contribution of up to 25% of compensation or $61,000, whichever is less, of each employee’s pay.
Business owners who set up SEP IRAs for their employees can deduct their contributions on behalf of employees. However, employees cannot contribute to their accounts, and the IRS taxes their withdrawals as income.
A Savings Incentive Match Plan for Employees (SIMPLE) IRA is also meant for small businesses and self-employed individuals. A SIMPLE IRA is best suited as a start-up retirement plan for small employers not currently sponsoring a retirement plan. Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions as well. All contributions are tax-deductible.
How does my IRA account earn money?
When you open an IRA, you can choose to invest in a wide range of financial products, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds. There are even self-directed IRAs (SDIRAs) that permit investors to make all the decisions and give them access to a broader selection of investments, including real estate and commodities. Only the riskiest investments are off-limits.
Whenever the investments in your account earn interest or a dividend, that amount is added to your account balance. How much your account earns is dependent on the investments you select and the amount of time you have until withdrawing your earnings.
Withdrawing from Your IRA Account
Similar to a 401(k) account, if you withdraw before the age of 59 ½ you will incur a 10% penalty tax, in addition to any taxes on the withdrawal. Additionally, there are some exceptions to this penalty for certain hardships, but the general rule of thumb is to wait until retirement before taking distributions.
Required Minimum Distributions
Required Minimum Distributions (RMDs) are minimum amounts that you must withdraw annually from your IRA accounts. RMDs act as safeguards against people using retirement accounts to avoid paying taxes. You must begin withdrawing from most retirement accounts by April 1 following the year the account holder reaches 72 years old. From there, the account holder must withdraw the RMD amount each year thereafter based on the current RMD calculation. The IRS has a worksheet to help determine how much must be withdrawn.
RMDs are required for Traditional IRAs, SEP IRAs, and SIMPLE IRAs. However, RMDs are not required in the account holder’s lifetime for Roth IRAs. In other words, with a Roth IRA, you can leave your savings in your account for as long as you live, and you can keep contributing to it indefinitely as long as you earn an income, and your MAGI doesn’t exceed the annual limits for making contributions.
Should I have both a 401(k) and an IRA?
If possible, an IRA shouldn’t be your only retirement savings account. If you have access to a 401(k) plan through your employer, consider maxing out your 401(k) contribution first. Here’s why:
- If your employer matches contributions, you automatically get a 100% return on part of your investment.
- Your taxes are deferred on a 401(k), so your money grows faster.
- You receive a tax deduction for the year when you contribute, which lowers your current taxes.
Consider funding your 401(k) first to ensure you receive the full match from your employer, then work on maximizing your Roth account. If you have any funds left, you can focus on rounding out your 401(k). Learn more about how U1 can help you save for retirement by scheduling an appointment with a U1 free Financial Advisor.
Further Resources on IRAs
Learn more about IRAs with these helpful resources.
- Investopedia. Investopedia is an online resource that offers articles on various topics related to IRAs, including types of IRAs, contribution limits, and rollover rules.
- Securities and Exchange Commission (SEC). The SEC's Securities and Exchange Commission (SEC) website provides information on IRA investments, fees, and risks associated with investing in IRAs.
- Internal Revenue Service (IRS). The official website of the IRS provides information on different types of IRAs, contribution limits, and rules for withdrawing funds.
The Bottom Line
Saving for retirement is one of the most important things you can do to ensure your financial freedom in the future. An IRA account allows you to save more beyond what your employer-sponsored plan does, and it may even offer more investment options. It is also a good option if your employer doesn’t offer a retirement savings vehicle.
Source: Your Money Further™ Personal Money Solutions: https://www.yourmoneyfurther.com/personal-money-solutions/investing/what-is-an-ira-heres-what-you-need-to-know
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