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In this post, we're going to talk about IRAs. You may have an IRA or have heard of one from your employer. There are many kinds of IRAs out there, and we're going to discuss the more common ones in this post.
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What Is An IRA?
An individual retirement account (IRA) is a type of investment account that allows you to build savings for retirement with tax advantages. There are several types, including Traditional IRAs, Roth IRAs, Rollover IRAs, SEP IRAs, and SIMPLE IRAs.
The two most common IRAs are traditional IRAs and Roth IRAs. Let's look at a few quick differences when you compare a traditional IRAs vs. a Roth IRA.
In a traditional IRA, if you qualify for a tax break, contributions can reduce how much you pay in income taxes now in exchange for paying taxes on the money when you withdraw it in retirement.
In a Roth IRA, contributions are made with after-tax dollars and can grow tax-free and be withdrawn at retirement tax-free, given certain conditions are satisfied.
With a Rollover IRA, you “rollover” money from another retirement plan into this traditional IRA. Other retirement plans include a 401(k) or 403(b).
Why Invest In An IRA?
It's generally agreed that you need 80 percent of your annual salary as annual income for your retirement years. That means, if you make $100,000 per year now, you'll need $80,000 per year for retirement.
With IRAs offering tax-deferred or tax-free growth, you can reach your retirement goals faster than if you open a traditional brokerage account.
It's even better if you can reach the IRA contribution limit each year. For 2020, if you meet the income requirements and are under age 50, you can contribute up to $6,000 for either a traditional IRA or a Roth IRA. If you're over 50, the limit is $7,000.
If you open an IRA with Charles Schwab Bank, you can get up to $500 added to your account for free.
What Types Of IRAs Are There?
Below, let's discuss the most common types of IRAs.
What is a Traditional IRA
When you contribute to a traditional IRA, you generally can deduct the amount from your income on your tax return. After that, your money grows tax-deferred, and you won't owe taxes on your money or the gains until you withdraw the money.
Unlike a Roth IRA, you can contribute to a traditional IRA regardless of income. There may be limits as to what you can deduct based on your income or if you have a retirement plan at work, such as a 401(k).
Earnings grow tax-deferred, however, there is a 10% tax penalty if you withdraw funds before age 59½. Some exceptions apply, such as first-time home purchases and some college expenses. You also must begin withdrawing money by age 72.
There are no income limits to a traditional IRA. You can contribute $6,000 in 2020 if you are under age 50, and you can contribute $7,000 in 2020 if you are age 50 or older.
What is a Roth IRA
When you contribute to a Roth IRA, your contributions are made with after-tax dollars, and your money grows tax-free. You also may receive tax-free withdrawals when you retire with the conditions that you are age 59½ or older, and the account must be at least five years old.
If you withdraw early, you will have to pay taxes on your earnings and be subject to a 10% penalty tax. There are exceptions to this. Money can be withdrawn for a qualifying first-time home purchase, for disability, for some college expenses, and certain other less common situations.
The power of a Roth IRA is seen when your money compounds over many decades and can be withdrawn tax-free.
You can only contribute to a Roth IRA is your modified adjusted gross income (MAGI) is within the income limits. In 2020, the limit is $139,000 if you're single, and $206,000 if you're married and filing jointly.
You can contribute up to $6,000 in 2020 if you are under age 50 and $7,000 if you are age 50 or older.
The advantage of a Roth IRA is that if you believe you will be in a higher tax bracket at retirement, you have paid all of your taxes upfront and won't pay them again on withdrawal, as mentioned above.
What is a Rollover IRA
If you had a previous employer-sponsored account, such as a 401(k) or 403(b), you could roll over these plans into a Rollover IRA and still keep the tax-deferred status of the assets within the account.
If you had a 401(k) plan at your previous job and you switched to a new job, one option would be to open a Rollover IRA and “rollover” your 401(k) into that account.
What is a SEP IRA
A SEP (simplified employee pension) IRA is a retirement account designed for business owners and self-employed individuals, generally with few or no employees. While a traditional IRA limits your contributions to $6,000 in 2020, you can contribute up to the lesser of $57,000 or 25% of your compensation to a SEP IRA account in 2020.
Contributions are made before-tax, and, similar to a traditional IRA, you pay taxes on your earnings during retirement. SEP IRAs are set up by an employer, and the employer is permitted to make contributions to the accounts of eligible employees, including themselves.
What is a SIMPLE IRA
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is similar to a 401(k), though generally offered by smaller companies (100 employees or less) because it's easier to administer. Employees can contribute up to $13,500 annually in 2020. Those age 50 and older can contribute up to 16,500.
Benefits and Drawbacks of IRAs
There are many benefits and some drawbacks to having an IRA. While I believe that the advantages far outweigh the disadvantages, everyone's situation is different. Below are some benefits and drawbacks of opening an IRA.
Inside both traditional and Roth IRAs, your assets grow tax-free. You will not pay taxes on earnings while your money is in the account.
Investments generally grow much faster than traditional savings. While top savings accounts currently offer around 1.15% APY, investing in index funds, historically, has averaged approximately 8-9% per year, over the past few decades. Mutual funds are similar.
Bonds can yield double that of a high-yield savings account. While this is no indication of future results, it does make the argument that excess money is often better placed into investments.
Traditional IRA contributions can be deducted from your income, in most cases, up to a certain limit. Roth IRA contributions are made with after-tax dollars, and earnings are not taxed upon withdrawal given all conditions are met.
Investments can drop in value, such as if the stock market could have a bad year. This means that you can lose money. There are strategies to mitigate loss, which we'll discuss in a future post, and there are strategies to help your gains, given time.
You will pay a 10% tax penalty for withdrawing from your IRA if you're younger than 59½ on top of any other taxes owed for your earnings. You also need to have had the IRA open for five years to avoid tax penalties. There are some exceptions, which include: A qualified first-time home purchase, and some college expenses.
Wrapping It Up
Opening and contributing to an IRA is an excellent way to save for retirement. Whether you're in your 20s, 30s, 40s, or closing in on retirement, it's never too late to start saving. When you've reached two or more years of living expenses invested, it is said that you have reached step 5 of 7 of financial freedom.
What is your preferred way to save for retirement?