When it comes to saving for retirement, there are few vehicles that are as flexible as an IRA. These accounts allow investors to put money into a tax-advantaged option that can provide tax-deferred or tax-free growth for decades.
What Is An IRA
Simply stated, an IRA is an individual retirement account. These accounts provide tax-advantaged retirement savings for those who might not have access to a work-based retirement plan. Many who have a 401k or similar retirement plan available at work can also take advantage of an IRA.
What Types Of IRAs Are Available
There are three types of IRAs that are open to different people. Most common are the traditional and Roth IRAs. Those who are self-employed can take advantage of a SEP-IRA. The SEP stands for a simplified employee pension.
How Do IRAs Work?
The traditional and Roth options come with $6,000 contribution limits for workers who have not reached age 50. Those who have exceeded this age are allowed to make $1,000 catch-up contributions each year. This brings the maximum contribution up to $7,000. While not as impressive as the contribution limits that are available for 401k plans, those who max out an IRA should be able to build up a large nest egg by the time they can make withdrawals. A SEP-IRA comes with a hefty $57,000 contribution limit as of 2020. The limit is the lesser of 25% of income or $57,000. This allows those who work for themselves to shield much of their current income from taxation.
One big difference between a traditional IRA and a Roth IRA is when the accounts are taxed. Those contributing to a traditional IRA contribute pre-tax income. This will cut an individual’s taxable income in the year in which the contribution is made. For example, a saver who contributes $6,000 at a 12% marginal tax rate would save $720 in taxes for the current year. That money would then grow on a tax-deferred basis. The taxation would take place whenever a withdrawal takes place, and it would occur at whatever the individual’s marginal rate is at that time. Those who take out their money before age 59 1/2 also incur a 10% early withdrawal penalty.
A Roth IRA flips that tax treatment. There are no tax savings on the front end. Money that goes into a Roth IRA is treated as regular income. Any growth within the account occurs on a tax-free basis. Additionally, the withdrawals take place on a tax-free basis. The IRS views the income taxes as having been paid on the front end. Roth IRAs allow for the penalty-free withdrawal of contributions (but not growth), and they do not have required minimum distributions. This is different from traditional IRAs that require minimum distributions starting at age 70 1/2. These required distributions tend to grow over time and can lead to a hefty tax bill.
How Can You Contribute?
Contributions to an IRA can take place in multiple ways. If a retirement saver deals with a local bank that has a broker, he or she might transfer the funds from their checking account to the broker. Additionally, they could mail a physical check or initiate an automatic withdrawal on a regular basis to fund an IRA.
How Do You Open An IRA
There are many online brokerages that offer IRA accounts. These brokerages tend to come with relatively low fees, and when considering how to open an IRA, it’s a good idea to look into opening an online brokerage account. Those who may not feel comfortable with online banking might want to go to a local broker. There are well-known brokerages that provide local offices. Additionally, many banks have stockbrokers who can help clients open accounts. This can provide additional peace of mind for those who are not comfortable with modern technology.
According to the experts at SoFi Invest, “If you are leaving a job with an employee-sponsored retirement plan, you can rollover your 401(k) into a Traditional IRA to potentially give yourself better investment options and lower fees.” Those who take advantage of this option can roll some of the money into a Roth IRA if they’re looking to cut down on their taxable income in the future. It’s also possible to let the money ride in a traditional IRA and put off paying taxes to some future date.
Saving in an IRA is a great way to build wealth for the future. From stocks to bonds to real estate, IRAs can hold a number of investments that can provide money to live on during retirement.