An individual retirement account (IRA) provides tax advantages for your investments. Depending on the type of IRA, taxes are deferred on your contributions or your contributions will be subject to tax-free growth. Either way, with an IRA you will benefit from compound interest over decades as you prepare for your retirement years.
How Does an IRA Work?
With a traditional IRA, you can deduct contributions from your income tax return. Your taxes are deferred and you will not pay them until you withdraw the money in retirement. Because a lower tax bracket is common when you no longer work, you can benefit from paying a lower tax rate on those funds.
With a Roth IRA, you pay taxes on the money when you add it to your account. This provides tax-free growth, and if you follow the account guidelines, you can enjoy tax-free withdrawals in retirement. Roth IRAs are also flexible because you can remove your contributions at any time, although you typically need to leave earnings on the contributions in your account until retirement.
Rollover IRAs are transferred from a workplace retirement plan such as a 401(k) or a 403(b) to a traditional IRA. Like traditional and Roth IRAs, a rollover account must meet certain IRS guidelines such as tax-free contribution limits.
Employer IRAs include SIMPLE plans for small business owners and their employees and SEP plans for self-employed taxpayers. Although these plans are similar to traditional IRAs, they have higher contribution limits and different rules for required minimum distributions.
Benefits of Investing in an IRA
An IRA lets you save more for retirement than what you have in a 401(k) or other employer-sponsored investment plan. Ideally, you should strive to save about 85% of your pretax income for each of your retirement years. Contributing to more than one retirement account can help you reach that goal. You may also have a pension and/or qualify for Social Security benefits.
In addition, IRAs often provide more diverse investment opportunities than you have available in a 401(k) or 403(b) plan. You can invest in different types of funds while still taking advantage of tax-free or tax-deferred growth. Almost any kind of mainstream investment can be held by an IRA, including but not limited to cash, mutual funds, savings accounts, certificates of deposit (CDs), and exchange-traded funds (ETFs). You can choose the right mix for your savings goals and risk tolerance.
An IRA is a great option if you do not have access to a 401(k) or 403(b) account through your employer. According to Pew Charitable Trusts, up to 35% of employees in the private sector do not have a retirement investment plan through their jobs. Anyone who earns taxable income from a job or has a spouse who gets taxable income can contribute to an IRA for retirement.
Some investors who contribute to an IRA may qualify for a tax benefit called the Retirement Savings Contributions Credit. This credit can provide up to $1,000 per year when you save for retirement if you earned AGI of less than $30,750 for a single taxpayer or less than $61,500 for a married couple filing jointly.
Unlike 401(k) accounts, IRA accounts do not allow you to take a loan against your investments. However, even with a 401(k), loan availability depends on the parameters set by your plan administrator or employer.
Each year, the IRA establishes limits for the amount you can contribute to your IRA without paying taxes on the money. You can typically transfer funds from other retirement accounts and open rollover IRAs separately from those contribution limits. However, it’s important to have an expert help you with those types of transfers since they can be complicated.
For both 2019 and 2020, taxpayers can contribute up to $6,000 per year in pre-tax funds to an IRA account. Those older than 50 can contribute up to $7,000 annually. These limits represent an increase from the 2018 limits. In comparison, 401(k) accounts have a contribution limit of $19,000 per year.
After age 59 1/2, you can withdraw funds from your IRA without tax penalties. If you take an early distribution, you will have to pay tax penalties of about 10% as well as income tax on those funds. SIMPLE IRA plans have a tax penalty of 25%.
In rare situations, you can take an early withdrawal from an IRA without a tax penalty. This exception applies if the money will fund a first-time home purchase for you or a qualified family member, in the case of disability in which you can no longer work, or for eligible college or university expenses.
Required Minimum Distributions
Traditional IRA plans require minimum distributions (RMDs) when you reach age 70 1/2. Although Roth IRAs do not have a required minimum distribution for the original account holder, RMDs do apply if another person inherits a Roth IRA.
Choosing the Right Type of IRA
Traditional IRAs are ideal for those who want to lower their taxable income by deducting contributions to this type of account. This feature also makes it more affordable for individuals to contribute to retirement.
However, it’s important to keep in mind that with a traditional IRA, you will have to pay taxes upon withdrawal, and we cannot predict how the tax rate and system may change over decades. The Roth IRA avoids this problem because you prepay your taxes when you contribute.
On the other hand, Roth IRAs are subject to annual contribution limits. For 2020:
- If you are filing jointly with your spouse and together you have modified adjusted gross income (MAGI) below $196,000, you can contribute to a Roth. Those with MAGI between $196,000 and $206,000 can make a partial Roth contribution.
- If you are married filing separately but live with your spouse in 2020, you must make below $10,000 to contribute to a Roth IRA.
- If you are a single taxpayer, you can contribute to a Roth with 2020 MAGI of less than $124,000. Between $124,000 and $139,000, you are eligible for a partial contribution.
If you decide to convert a traditional IRA to a Roth IRA, talk to a tax professional. They can guide you through this sometimes complex process.
Opening an IRA
Most financial institutions offer IRAs, including investment firms, credit unions, and banks. When selecting an IRA provider, make sure you ask about the types of investments they offer, fees associated with the account, and other details that may influence your decision. In-person education sessions, guidance, and resources through your provider also provide significant benefit if you are new to retirement savings. Some accounts have monthly fees, while others have no monthly fee but charge a fee for each transaction.
If you have investment experience, you can choose a brokerage that offers self-directed IRAs. These accounts require more input into how your IRA holdings are invested. With a full-service IRA, a broker invests the IRA funds on your behalf depending on your provided investment goals.
Because of compound interest, you can earn more profit in your IRA the earlier you begin contributing. However, investments carry risk, and the value fluctuates over time, so it can be difficult to pinpoint exactly how much your account will be worth by the time you retire.
However, if you invest $1,000 50 years before you retire, that contribution will grow to about $18,000. Another estimate indicates that if you put $5,500 into an IRA every year for three decades, based on the historical average returns of the stock market your money will be worth more than $800,000 when you retire. That amount could make a big difference in the quality of life you can enjoy when you are no longer working.
In addition, it’s never too late to start an IRA. A study from the Employee Benefit Research Institute indicated that more than 50% of IRA accounts with owners age 60 or older saw profits increase over three years.
If you want to learn more about investing for your retirement, sign up at Raging Bull today. Our experts provide webinars, free e-books, and other helpful resources for novice traders.