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What is an IRA and Should I Invest in One?

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If you’re getting ready to save for retirement, you may be thinking of opening what’s known as an Individual Retirement Account (IRA). This is a common retirement savings tool to help you make the most of your hard-earned money. There are many different types of IRAs to choose from. Making the right choice all depends on your finances and future plans for your savings.

Yellow notepad with pen svg icon Lesson Notes:
  • An individual retirement account (IRA) is a tax advantaged account used to save for retirement.
  • Money contributed to an IRA can be invested in stocks, bonds and other assets.
  • IRAs come with different rules, contribution limits and tax benefits and should be selected based on your needs and financial goals.

What is an IRA?

An individual retirement account is one of the best ways to save for retirement. You can deposit a certain portion of your earnings into an IRA to receive certain tax advantages. The money then can be invested in stocks, bonds and other assets, which may accrue in value over time. This may help you stretch your money even further in retirement. You can manage your investments as you see fit to stay in control of your finances.

However, once your money goes into an IRA, you may have to pay a penalty if you take it out before you reach a certain age. The terms and conditions vary based on the type of IRA, so make sure you find the right choice for your finances.

Different Types of IRAs

Traditional IRA

A traditional IRA is a self-managed retirement account used to save for retirement. However, it is not the same as a workplace or employer-sponsored retirement savings plan. You can also use this type of account in conjunction with a 401(k) to supplement your retirement income. For 2021, the contribution limit for traditional IRAs is set at $6,000 per year. People 50 and older can contribute another $1,000 per year in catch-up contributions.

Withdrawals from your traditional IRA may be taxed as regular income even in retirement. You can start making withdrawals from your account as soon as you reach the age of 59 ½. If you take out money before then, you may have a 10% penalty on top of income tax, but some exceptions apply. Traditional IRAs come with what are known as required minimum distributions (RMDs). This means you must start withdrawing money (taking distributions) out of your account once you reach the age of 72.

Investments in your traditional IRA grow tax-deferred, meaning you don’t have to pay taxes on the growth of the investments until they are withdrawn. You can also deduct contributions from your taxes. The government uses a sliding scale based on income to determine how much you can deduct from your taxes. The more money you make, the less you can deduct from your taxable income.

If you or your spouse has an employer-sponsored retirement savings plan, contributions to your traditional IRA may not be tax-deductible. You can deduct your contributions to a 401(k) and IRA from your taxes as long as you stay within the eligibility requirements.

You might want to focus on contributing to your 401(k) to get the maximum matching contribution from your employer. However, your IRA may offer lower fees than your 401(k). Both options help you save for retirement, but it’s best to research the terms and conditions to maximize your tax benefit.

Roth IRA

A Roth IRA is slightly different in that contributions are not tax-deductible; however, there are still benefits to putting your money in this type of account. All qualified withdrawals from Roth IRAs are tax-free and you don’t have to pay taxes on any of your investment gains. They also don’t come with required minimum distributions, which means you don’t have to start making withdrawals once you reach a certain age. Since you’ve already paid taxes on your contributions, you can make withdrawals at any time without paying a penalty. At age 59½, you can withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least five tax years.

Like a traditional IRA, Roth accounts come with annual contribution limits.

If you are single and make $125,000 or less a year, you can contribute up to $6,000 if you are younger than 50, or $7,000 if you’re age 50 or older. If you make between $125,000 and $140,000 a year, you can make a partial contribution. If you make more than $140,000 a year when filing as single head of household, or married filing separately, you are ineligible for direct Roth IRA contributions.

If you are married and you make $198,000 or less a year when filing jointly, you can contribute up to $6,000 or $7,000. If you make between $198,000 and $208,000 a year when filing, you make a partial contribution. If you make more than $208,000 a year when filing jointly, you are ineligible for direct Roth IRA contributions.

SEP IRA

These types of accounts are reserved for self-employed individuals with few to no employees. They work just like traditional IRAs, which means all contributions are tax-deductible, and investments grow tax-deferred until retirement when withdrawals are taxed like regular income. Unlike other types of IRAs, the employer makes all the contributions. If the employer offers a SEP IRA to one worker, it must be made available to all employees.

There are limits to how much you can contribute each year. The limit is set at 25% of your income or $58,000, whichever is less. They also come with RMDs, which means you must start withdrawing money by the age of 72. Unlike other types of IRAs, you can’t start contributing more to the account once you reach the age of 50, also known as “catch-up” contributions. Again, you may have to pay a penalty if you take money out of your account before you reach the age of retirement.

SIMPLE IRAs

SIMPLE IRAs (Savings Incentive Match Plan for Employees Individual Retirement Accounts) are reserved for employers and business owners with fewer than 100 employees. Employers may set requirements for how long employees must work at the company before earning the employer-matched contribution.

These accounts work just like traditional and SEP IRAs. Contributions are tax-deductible for the employer and withdrawals may be taxed like regular income in retirement. Employer contributions are mandatory. Employee contributions to a SIMPLE IRA plan are not deductible by participants but the contributions may lower their income.

Employees are free to contribute up to $13,500 a year, while those over the age of 50 can contribute up to $16,500 per year.

How to Get One

Now that you are familiar with the different types of IRAs, you can start finding an account that works for you. You can visit your local bank or credit union to get started. Compare their different IRA options to see what’s available. You can also consult an investment broker or financial advisor to help you manage your investments. Consider partnering with a financial professional that can help you reach your retirement goals and navigate the stock market.

The financial industry has also started relying on what is known as “robo-advisors.” These are low-cost software programs that use algorithms to manage your investments. The program will manage your investments based on the company’s algorithms. This is often less expensive than consulting with a broker in person but may lack personalized advice.

Should You Invest in One?

As you can see, investing in an IRA is a great way to save and plan for retirement, but make sure you don’t need your money until you reach a certain age to avoid having to pay a fee or penalty.

You should also learn about the different investment options available to you to make sure your holdings grow over time. Stay in control of your retirement savings as the stock market continues to fluctuate. If you’re not sure whether you should spend your money or invest in an IRA, use the retirement calculator below to make the most of your earnings.

PLEASE NOTE: Limits and figures may be subject to change in the future. The information provided is for educational purposes only and should not be considered recommendations or advice. Please consult the appropriate financial, tax or legal professional to determine whether the strategies presented in this article are appropriate for your situation.

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