What is an IRA?
“IRA" stands for Individual Retirement Arrangement but is more commonly known as Individual Retirement Account. IRAs allow you to save for retirement while enjoying tax benefits. They're a wise option for people who want to build up a nest egg.
Just about anyone can open an IRA if they have earned income. In other words, you must have income from an employer or be self-employed to participate in an IRA.
There are four basic kinds of IRAs: traditional, Roth, SEP, and SIMPLE. In each case, you can choose which investments your contributions will be placed in, such as stocks, bonds, or certificates of deposit. This helps you control the level of risk you're comfortable with. Before you make any decisions, it's always a good idea to contact a tax professional on the best option for your situation.
Let's go over each type of IRA.
Traditional IRAs are retirement vehicles that have a major advantage: in most cases, you can deduct the amount you contributed to your IRA from that year's tax return. For example, if you deposit $3,000, you can report $3,000 less income on your tax return, which will likely lower the amount of taxes you owe.
Money invested in a traditional IRA also grows tax-free. In other words, your investments can grow without any taxes being taken out, which can be a big boost to your savings. Your total contributions to all of your traditional and Roth IRAs cannot be more than: $6,000 ($7,000 if you're age 50 or older). Contribution limits change each year.
A downside to traditional IRAs is that once you draw on the funds during retirement, you will have to pay taxes on that money. You also will usually incur a penalty if you withdraw from the account before age 59½, and under the provisions of the SECURE Act (Setting Every Community Up for Retirement Enhancement), if your 70th birthday is July 1, 2019 or later, you do not have to take withdrawals until you reach age 72. Otherwise, you must start withdrawing at age 70½.
Like traditional IRAs, Roth IRAs are for individuals. They also give you tax-free growth, just like their traditional counterpart. But unlike traditional IRAs, they are post tax and don't give you a tax deduction on the front end. For example, if you contribute $3,000 to a Roth IRA, you cannot deduct that amount from your total income, and your tax burden will not be reduced. Like traditional IRAs, there are income limitations and contribution limits.
However, once you draw on your Roth IRA in retirement, you don't have to pay taxes on that money. In most cases, it's also possible to withdraw money without a penalty from your Roth IRA before you reach 59½, and you can keep your money in the IRA past 70½. The five-year rule for Roth IRA withdrawals of investment earnings requires that you hold your account for at least five years before you can tap into those earnings without incurring a penalty.
SEP and SIMPLE IRAs
SEP and SIMPLE IRAs are for business owners and their employees, not individuals. SEPs, or Simplified Employee Pensions, are for small-business owners or self-employed people. One advantage of a SEP IRA is they have higher contribution limits than traditional or Roth IRAs. SIMPLE IRAs are retirement savings accounts for small companies. If you're a business owner, these two types of accounts might make sense for you.
You can choose from a variety of IRA options with significant tax advantages. But IRAs aren’t the only way to help you prepare for retirement and beyond. If you’re employed, your company may offer other options including a 401(k). It may be worth considering the best way to prepare for your future.
IRAs vs. 401(k)s
401(k)s are another type of retirement account, but they're different from IRAs. 401(k)s are set up by your employer; unlike IRAs, an individual can't establish one on their own. One major advantage to a 401(k) is that sometimes an employer will match your contribution, effectively giving you “free" additional money to put toward your retirement. Also, 401(k)s have a higher contribution limit than IRAs.
You don't have to choose between these two retirement tools. If your employer offers a 401(k), you can participate in that program and also set up an IRA, giving you two vehicles for savings. If you're self-employed or your employer doesn't offer a 401(k), you can still get started on your retirement savings with an IRA. In 2020, the maximum contribution amount for an IRA is $6,000, or $7,000 if you're 50 or older.