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What Is An IRA And How Does It Work?

13-minute read

There’s no getting around it: You need a plan for how you’re going to financially support yourself in retirement.

While many workers plan to rely heavily on Social Security, these benefits are typically not sufficient asyour only source of income in retirement – according to AARP, the estimated average Social Security retirement benefit in 2020 is $1,503 per month.

This means that saving for retirement is vital, no matter how far off it may seem to you.

There are a variety of different types of accounts that people can use to plan for how they’ll support themselves in retirement. One type of account: the IRA. What exactly is an IRA, and does having one make sense for you? Let’s take a look.

What Is An IRA?

IRA stands for “individual retirement account.”

Like many other savings accounts that are used to plan for retirement, an IRA is a tax-advantaged investment portfolio. What does that mean?

With regular investment accounts, the IRS has rules for how they must be taxed, and you’ll typically pay taxes on any money you generate from those investments. Tax-advantaged accounts, such as those you use to save for retirement or some accounts that parents use to save for their child’s college tuition, allow investors to avoid certain taxes and even contribute pre-tax income if they choose.

Unlike a 401(k), which is specifically an employer-sponsored retirement plan, an IRA can be opened by anyone, making it a great choice for individuals who are self-employed or whose employers don’t offer a work-sponsored retirement plan. Even if you already have an employer-sponsored retirement savings account, you can still choose to open an IRA on your own to further boost your retirement savings.

How An IRA Works

To open an IRA, you’ll need to go to a financial institution that offers them. These days, there are plenty of options for even newbies to easily open an account. Many online brokerages and robo-advisors make it easy and do a lot of the work for you, so you don’t need to have extensive investment knowledge to have a strong portfolio.

Almost anyone can open an IRA account, though what types you’re eligible for depends on certain factors. To be able to contribute to an IRA, the main requirement is that you have some form of taxable compensation. Note that we didn’t say taxable income, because not all income can be contributed to an IRA. For example, you aren’t allowed to use money earned from an investment property to contribute to your IRA.

Income that is eligible for IRA contributions includes compensation that you receive from working (including your wage or salary, plus any tips or bonuses you earn), commissions, self-employment income, alimony or separate maintenance (in certain cases) and nontaxable combat pay.

Eligibility, restrictions, limits and penalties all vary depending on what type of IRA you’re talking about, so let’s take a look at each one so you can figure out which is best for you.

Traditional IRA

A traditional IRA is a tax-deductible retirement account. What this means is that you can deduct any contributions you make on your taxes for that year, effectively lowering your taxable income.

It’s important to note that although you’re getting a tax deduction now, you will have to pay taxes on that money eventually. Once you retire and start receiving regular distributions from your traditional IRA, you’ll pay taxes on money as you would any other income; how much you’ll pay will depend on which tax brackets apply to you.

This is where the difference between traditional and Roth retirement accounts becomes so important; with a traditional account, you get to save the tax-free income now and pay taxes on it later, and with a Roth account, you pay taxes now and get tax-free income in retirement. When deciding which one makes the most sense for you, you should think about whether you’ll have a higher income (and thus, larger tax burden) in retirement than you do right now.

Traditional IRAs also have rules for how and when you can withdraw money, as well as a minimum distribution requirement.

While these accounts have some exceptions for making withdrawals before the allowed age (59½), in most cases if you take an early withdrawal, you’ll not only pay regular income tax but also an additional 10% penalty on the withdrawal. Traditional IRAs also have what’s called a required minimum distribution, which is the minimum amount you have to withdraw from the account each year after you reach a certain age. In previous years (including 2019), the age at which you’d begin receiving required minimum distributions was 70½. For 2020, it’s 72.

Pros And Cons Of Traditional IRAs

Like Roth IRAs, there are some benefits and drawbacks to investing within a traditional IRA. Here’s what you need to know:

Pros

If you choose to contribute to a traditional IRA, you’ll take advantage of tax deductions right now. You’ll be able to effectively lower your taxable income for the current year. For some investorswith a high income, that can be a great feature.

It’s easy to build a diverse retirement portfolio with an IRA. When you put money in an IRA, it’s dispersed in a wide variety of stocks and bonds. This can offer financial protection for you: If one type of stock or bond is losing value, the odds are that another type in which you are invested is doing the opposite, increasing in value. This helps keep the overall value of your investments steady.

Cons

Although you avoid taxes as you contribute funds to a traditional IRA, you’ll be forced to pay taxes when you withdraw the funds. In addition to paying taxes on your withdrawals, you’ll be required to take a minimum distribution from this account. That means that you cannot delay taxes in perpetuity – you’ll have to pay them as you withdraw your funds.

Another drawback? The amount of money you contribute to an IRA is limited each year. These limits can change, but in 2020, you can contribute a maximum of $6,000 to an IRA. If you’re 50 or older, you can contribute a maximum of $7,000 in 2020.

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What Is A Roth IRA?

A Roth IRA is a type of retirement account that was originally created in 1997. The name of the account came from the primary sponsor of the bill, Senator William Roth.

With a Roth IRA, you can contribute to your retirement savings to take advantage of tax-free growth. Before you put any money into your Roth IRA, you’ll pay income tax on that contribution. Once you hit retirement age, you’ll be able to withdraw the funds without paying any penalties.

For 2020, you can contribute up to $6,000 to your Roth IRA if you’re under the age of 50. If you’re 50 or older, then you’re allowed to contribute $7,000. However, you’ll need to make less than $196,000 as a married couple or less than $124,000 as a single person to be eligible to contribute.

If you have reason to believe that you’ll have a higher tax rate in retirement, a Roth IRA may make more sense for you. With a Roth IRA, you contribute after-tax dollars and you don’t get a tax deduction on contributions. Then, when you enter retirement and make withdrawals from the account, you get to do so tax-free.

Roth IRAs also have a bit more flexibility when it comes to withdrawals, which can make them a more attractive choice than a traditional IRA for some.

Because your Roth IRA contributions have already been taxed, you can take that money out of your account at any time without penalty (as long as you’ve had the account for at least 5 years). Keep in mind, though, that you can only take out what you’ve already contributed. If the money has grown over the years due to compounding interest, that additional money is considered earnings, and you can’t withdraw it without penalty if you’re under 59½, with a few exceptions.

There’s also no minimum distribution requirement on a Roth IRA, provided you’re the original owner of the account (for accounts that have been inherited from someone who passed away, the rules are different).

Pros And Cons Of Roth IRAs

A Roth IRA can be a great retirement investment vehicle. Of course, there are pros and cons to every type of retirement investment vehicle. Let’s take a closer look.

Pros

The most obvious benefit is the tax savings you’ll getin retirement. If you’re already in a relatively low tax bracket, then it makes sense to take advantage of future tax savings. With a Roth IRA, you won’t have to pay taxes when you withdraw money during your retirement years.

Another benefit? Flexibility. You can withdraw the contributions from your Roth IRA whenever you’d like without having to pay that 10% penalty. Just remember, you must have had your account for at least 5 years and you can only withdraw contributions tax-free, not earnings.

The final advantage is that there are no required minimum distributions associated with a Roth IRA. Although your heirs would be required to take a minimum distribution, you have the option of leaving the money untouched during your lifetime. 

Cons 

One drawback to a Roth IRA is that there are income limits that may prohibit you from contributing to this type of account.

Single tax filers can make a full contribution to a Roth IRA if their modified adjusted gross income was less than $122,000 in 2019. For 2020, you can make that full contribution if your modified adjusted gross income is less than $124,000.

If you’re married and filing your taxes jointly, you can make a full contribution to a Roth IRA if your modified adjusted gross income is less than $193,000 in 2019. For 2020, this figure rises to $196,000.

The Big Difference Between Roth IRAs And Traditional IRAs

Is a Roth or traditional IRA better for you? That largely depends on when you want the tax break that comes with an IRA.

If you take out a traditional IRA, you’ll get your tax break as soon as you make your contributions. These contributions are tax-deductible and will lower your taxable income for the current year. But when you withdraw money from a traditional IRA, you will have to pay taxes on the money you take out. The IRS considers it as income.

With a Roth IRA, you’ll pay taxes on your contributions now. But when you withdraw money later, you won’t have to pay taxes on your contributions.

If you want the tax break now, a traditional IRA is the better choice. If you want that break during your retirement years, go with a Roth IRA.

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Additional Types Of IRAs

Traditional and Roth are the two main types of IRAs available to individuals; however, there are several other types that might be better suited to particular situations. Let’s take a look at some of these options.

SEP IRA

SEP IRAs are a good choice for small business owners or self-employed individuals. A SEP, or simplified employee pension, is a tax-deferred retirement account, meaning that contributions are tax-deductible.

With a SEP, contributions are made by the employer, not the employee. These plans allow flexibility for businesses in how much they contribute each year, depending on how well the business is doing in a given year. Employers have to contribute equally to each employee’s SEP, and can contribute up to 25% of the employee’s compensation or $57,000, whichever is less. The same limits apply to self-employed individuals contributing to their own SEP.

SIMPLE IRA

A Savings Incentive Match Plan for Employees, or a SIMPLE IRA, is another option for small business owners or self-employed individuals. In fact, it’s specifically aimed at small businesses with 100 or fewer employees.

With a SIMPLE IRA, an employer is required to contribute a certain amount each year to all employees’ savings. There are two ways employers can structure their contributions: as a match, where the employer must match employee contributions up to 3% of the employee’s total compensation, or as a “nonelective contribution,” where the employer provides a contribution equal to 2% of the employee’s compensation, regardless of whether the employee contributes to their plan or not.

In 2020, employees can contribute up to $13,500 to their SIMPLE IRA. If you’re self-employed, you can contribute up to this amount plus either the 2% fixed contribution or the 3% matching contribution. 

Rollover IRA

Say you have a tax-deferred retirement account (such as a 401(k)) with your employer, but you end up leaving your job. What happens to that money? You typically have a few options in these situations, one of which is to use a rollover IRA.

A rollover IRA allows you to move money from one tax-advantaged retirement account to another without losing the tax benefits the account offers or having to pay taxes or penalties on the funds.

Generally, you can rollover any pretax retirement account into all of the IRAs we mentioned, but be sure to speak with your tax advisor for more information specific to your situation.

IRA Contribution Limits

IRAs come with a limit to how much you can contribute each year. Individuals under 50 years of age can contribute up to $6,000 in 2020, while those age 50 and older can contribute up to $7,000.

Additionally, there are some limits to IRA eligibility and deductions for higher earners. To know whether these restrictions affect you, you’ll want to know your modified adjusted gross income. For tax purposes, your adjusted gross income is all the money you made in a given year minus certain tax-deductible expenses (such as health insurance expenses for self-employed individuals). Your MAGI is your AGI with some of those deducted expenses added back in. This number is important to know when determining your eligibility for a Roth IRA and whether you can take deductions on a traditional IRA.

Roth IRAs have income limits, so high earners might not be eligible to contribute to one. For 2020, single filers who have a MAGI of less than $124,000 can contribute up to the total limit; those whose MAGI is between $124,000 – $138,999 will have the amount they can contribute reduced; single filers with a MAGI of $139,000 or more aren’t eligible to contribute.

With traditional IRAs, if you already have a work-sponsored retirement plan (such as a 401(k)), you may be limited in how much you can deduct. For example, single filers or heads of household who have a work-sponsored plan can only take a partial deduction if they have a MAGI of more than $64,000 but less than $74,000, while similar filers with a MAGI $74,000 or more cannot take any deduction on their IRA contributions.

Investing In Your IRA

One thing that makes IRAs such a great retirement asset is that they’re relatively versatile in terms of the types of investments you can hold in them. In fact, there are only a few things that IRAs can’t be invested in, including life insurance and collectibles (such as art or antiques).

An IRA can hold investments in many different types of assets, including stocks, bonds, mutual funds or even real estate.

Your ideal asset allocation – meaning the balance of different investments you have in your portfolio – will depend on your own financial goals and your tolerance for risk. Typically, younger people are advised to have a slightly more aggressive investing strategy, since they have a longer time to save and can usually weather dips in the market, while those approaching retirement age might want to play it a little safer and keep their investment strategy a little more conservative.

If you have no idea how to create an investment strategy, no sweat. Online brokerages and robo-advisors typically have plenty of resources on how to get started and can even help you make selections based on some basic information about your financial goals. Or, if you want to talk to someone in person, you can also find a local brokerage firm to figure out what your strong IRA portfolio would look like.

Factors To Consider When Choosing An IRA Type

Both Roth IRAs and traditional IRAs have pros and cons. The right choice for you will depend on your unique situation. As you weigh your options, consider the following factors.

Your Current Age

One of the biggest factors in choosing the right retirement account is your current age.

If you are older or plan to contribute to your IRA into your 70s, then a Roth IRA is likely the better choice. At 70½, you’ll run into required minimum distributions with a traditional IRA that could negatively affect your retirement plans.

Your Eligibility 

If you are young and in a low tax bracket, a Roth IRA likely makes more sense. If you have matured into your high-paying career, a traditional IRA might be the better option to lower your taxable income for the current year. The income limits will likely affect your choice between these two retirement accounts.

Your Future Needs 

Finally, you’ll need to consider the plans that you have for these funds. Consider how much money you’ll need to retire and how you’ll be able to reach your goals within both retirement accounts. If you plan on earning more or less income in retirement, then you can adapt your tax strategy appropriately. 

Can you lose money when investing in an IRA?

No investment comes without risk. And IRAs are no exception. Depending on the performance of the stock market and the overall economy, the value of the investments in your IRA might rise or fall. It's normal for the value of your IRA investments to fluctuate. But IRAs are a long-term investment. What matters most is the value of your investments as you near retirement age. This is why many reallocate their IRA investments to safer, less volatile stocks and bonds as they get closer to their retirement day.

Are IRAs and 401(k)s the same thing?

No. A 401(k) plan is offered by your employer, while you take out an IRA on your own. You have the option of devoting a percentage of each paycheck to your 401(k) as a way to build money for retirement. A 401(k) also has different limits on how much you can contribute each year: $19,500 in 2020 unless you are 50 or older, in which case you can contribute a maximum of $26,000 annually. Your employer might also offer matching contributions that will help you build the savings in your 401(k) at a quicker pace.

When can you withdraw money from your IRA?

You can take money out of your IRA whenever you'd like. Taking money out too soon, though, will result in a costly penalty. Once you turn 59½, you can withdraw money from your IRA without any penalties. But if you take money out before that age, you will pay a penalty of 10% on the amount you withdraw. You'll also have to pay income taxes on withdrawals because the IRS considers these to be forms of income. You are required to make regular withdrawals from your IRA once you hit the age of 70½.

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