What is an Individual Retirement Account (IRA)?

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Definition:

An Individual Retirement Account, otherwise known as an IRA, is a tax-advantaged investment account meant to allow individuals to save for retirement.

🤔 Understanding an Individual Retirement Account

An Individual Retirement Account (IRA) is a type of tax-advantaged account that allows people to save money for retirement. IRAs have become some of the most popular methods of saving for retirement. There are several different types of IRAs. These include traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. All of these options allow you to invest your contributions in certificates of deposit, stocks, ETFs, and mutual funds. While all IRAs are tax-advantaged, the tax benefit comes at a different time and with different contribution limits depending on what type of IRA you’re using.

Example

Let’s say you want to start saving money for retirement. You do your research and decide that a Traditional IRA is right for you. You fund your account and choose investments. As of 2019, you can contribute up to $6,000 a year (or $7,000 a year if you’re over 50) and can deduct part or all of that amount on your income taxes, depending on your income. Over the years, you continue to put money toward your IRA every year. Later on, when you’re ready to retire (generally any time after the age of 59 1/2), you can start withdrawing money every month and withdraw from your IRA penalty-free, though you may still have tax liability. If you withdraw money early, in most cases you will pay a hefty penalty.

Takeaway

An IRA is like a piggy bank...

The piggy bank can only fit so much in it — But the amount that fits can be safer from taxes. If you have to break the piggy bank open before retirement, in most cases that will come with some pain.

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What are the different types of individual retirement accounts (IRAs)?

The four main types of IRAs are: 1. Traditional 2. Roth 3. SEP 4. SIMPLE

Traditional IRA

A Traditional IRA allows for potentially tax-deductible contributions. Whatever money you contribute to your IRA in a year, you can then deduct on your tax return depending on your income. If your IRA contribution was deductible, you won’t pay taxes on that money until you begin withdrawing from your IRA. When you do eventually withdraw from the account, you'll generally pay taxes on the withdrawals at the standard income tax rate based on your income at that time.

Anyone can contribute to a Traditional IRA. The amount that you can deduct may be limited based on the retirement plan offered by your (or your spouse’s) employer. In 2019, for example, a single person making more than $64,000 who is covered by a retirement plan at work can only partially deduct their IRA contributions. If that same person made $74,000 or more, they wouldn’t be able to deduct any of their IRA contributions.

Roth IRA

Unlike with a Traditional IRA, the money you contribute to a Roth IRA isn’t tax-deductible when you put it in. Don’t let that scare you away though!

With a Roth IRA, the growth in the account is tax-free. This means that you do pay taxes on the money you have contributed, then never again. Withdrawals from your Roth IRA, both the initial contributions and earnings, aren’t generally taxed if certain conditions are met.

If you’re willing to wait until you withdraw your earnings to get your tax break, this is can be an attractive feature of a Roth IRA.

The limitation to the Roth IRA is that those over a specific income limit (currently $137,000 for single individuals and $203,000 for those married filing jointly) can’t contribute to a Roth IRA. (Though, it’s possible to get around this restriction with what’s informally called a “backdoor Roth,” where an individual contributes to a Traditional IRA and then converts it to a Roth IRA.

SEP IRA

A SEP IRA (simplified employee pension) is used by self-employed people, independent contractors, and small-business owners.

As with a Traditional IRA, a SEP IRA allows you to see a tax benefit on your contributions.

An important element is that if you have a small business and contribute to a SEP IRA, you must also contribute to the retirement accounts of any employees you have. You must make this contribution at the same rate as your own contribution.

SIMPLE IRA

A SIMPLE (Savings Incentive Match Plan for Employees) IRA is designed for small businesses with 100 or fewer employees.

As with the Traditional and SEP IRAs, the contributions made to this type of account are tax-deductible.

A SIMPLE IRA is different than a SEP IRA in that a SEP IRA is employer-funded, and a SIMPLE IRA is mostly employee-funded with some employer contribution.

What is the difference between an IRA vs. a 401k?

You’re probably familiar with the concept of a 401(k), which is a tax-advantaged retirement account offered by many employers. Employees can contribute through automatic payroll withholding, and employers have the option to match some of those contributions.

So, how is an IRA different?

The first difference is the IRA contribution limit. The contribution limit for an IRA is $6,000, as of 2019. That is low compared to the contribution limit of $19,000 for a 401(k).

A 401(k) has the possibility of an employer match. Many employers who offer a 401(k) match up to a certain percentage of your contributions. Unlike with the SEP IRA and SIMPLE IRA, however, an employer is under no obligation to contribute to their employees’ 401(k).

With these key benefits for a 401(k), you might be wondering why you should contribute to an IRA at all.

While a Traditional or Roth IRA does not include an employee match, they are still attractive in that they allow you more control and flexibility. With a 401(k), you’re limited to whatever plan your employer chooses to provide. With an IRA, you have complete control over the provider you choose. You may also be able to contribute to both a 401(k) and an IRA for any given year.

Pros and cons of an IRA

Pros

  • There is usually a tax benefit, either on the front end for deductible Traditional IRAs or on the back end for Roth IRAs.
  • You have more flexibility in that while your employer picks your 401(k) plan, but you get to pick your IRA provider.
  • They allow you to save additional money for retirement, beyond what you can save with a 401(k) alone.

Cons

  • For the Traditional and Roth IRAs, the contribution of $6,000 is low compared to 401(k)s, SEP IRAs, and SIMPLE IRAs.
  • For the Roth IRA, there are income limits — currently $137,000 for single individuals and $203,000 for those married filing jointly. (Though a “backdoor Roth” strategy may help you get around those.)
  • For the Traditional IRA, you may not be able to deduct the entirety of your contribution, depending on your (or your spouse’s) employer-sponsored retirement plan.
  • The 401(k) may provide you with certain advantages, such as fiduciary protections, that IRAs do not offer.
  • IRAs may limit your liquidity into your retirement years.

How to open an IRA

Opening an IRA is not difficult, but there are some decisions you have to make first.

You’ll have to decide what type of investor you want to be. Do you want to be very hands-on, choosing all the investments yourself? Or would you prefer to go with a financial institution that chooses your investments for you?

There are plenty of options for those who want to be hands-on with their investment decisions. And, in recent years, more and more providers are offering robo-advisor services as well.

Here are some of the most popular IRA providers on the market:

  • Merrill Edge
  • TD Ameritrade
  • E-Trade
  • Vanguard
  • Charles Schwab
  • Fidelity
  • Wealthfront
  • Betterment
  • SoFi

Once you’ve chosen an IRA provider, getting started is relatively easy. You can open your IRA on the provider’s website and fill out some information about yourself.

Once you set up an account, you’ll have to set up a plan to fund it, typically through a bank transfer or by rolling over or transferring from a different retirement account.

The final step to really getting the most out of your IRA is to set up your investments. Some financial institutions may offer guidance or advice to help.

You can also seek advice from a financial advisor about which investments are right for you. Or you can choose your investments yourself.

How much can I contribute to my IRA?

Individual Retirement Accounts (IRAs) have contribution limits. The IRS sets contribution limits for IRAs and usually changes them year-to-year. Updated limits can be found on the IRS website.

Here are the IRS contribution limits for 2019:

  • Traditional and Roth IRA: For both the Traditional IRA and the Roth IRA, there is an annual contribution limit of $6,000. For those who are 50 years of age or older, the contribution limit is $7,000.
  • SEP IRA: Individuals contributing to a SEP IRA may contribute either $56,000 per year or up to 25% of their annual income, whichever is lower.
  • SIMPLE IRA: Employees contributing to a SIMPLE IRA may contribute up to $13,000 per year. For those individuals who are 50 years of age or older may contribute an additional $3,000 per year.

How much money can an Individual Retirement Account (IRA) earn?

The amount of money you earn in your IRA depends on many factors. Those factors include when you start investing, how much you invest annually, what types of investments you choose, and the performance of those investments.

No level of return is even guaranteed when you’re investing in the stock market — And your account value can go down as well as up.

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