Planning to save money for your golden years? Individual retirement accounts (IRAs) could be an excellent option, as they offer different investment alternatives and some tax benefits.
However, before putting your hard-earned money into an IRA, you should learn more about multiple things, such as the different account options you can choose from, the investment strategies you can implement, and the rules you’ll be required to follow.
Fortunately, this comprehensive guide contains all the information you should know about an individual retirement account (IRA). Read on!
Understanding the Individual Retirement Account (IRA)
An IRA is a way to save money for retirement that offers several tax benefits and multiple investing opportunities to anyone who earns an income, including self-employed people. However, there are many other things to learn about these accounts.
Definition of an IRA
Essentially, an IRA is a retirement savings account that anyone with an earned income can use to save for the long term. However, unlike other options, these accounts allow money to grow tax-free or tax-deferred.
The Purpose and Importance of an IRA
Although they were originally designed for self-employed individuals, anyone who earns an income can contribute to an IRA.
That means people with or without access to employer-sponsored plans, such as a 401(k) or 403(b), can open these accounts to enjoy their tax advantages, add flexibility to their portfolios, or just boost their savings.
How an IRA Works
IRAs must be opened with an institution approved by the Internal Revenue Service (IRS), including brokerage companies, banks, federally insured unions, and savings or loan associations.
If you open an IRA, you can contribute funds to invest in different financial products, such as the following:
- Exchange-traded funds (ETFs)
- Mutual funds
- Precious metals
The number of investment options and how the account works may vary depending on the type of IRA you choose. Self-directed IRAs, also known as SDIRAs, give investors the power of decision, for example, and offer many more investment products.
The rules regarding taxation, eligibility, and withdrawals are also different for each individual retirement account. However, they all work similarly: you just have to open your IRA, fund it, and manage it as permitted.
Key Features of an IRA
Although account features can also vary by type, this is what makes IRAs so attractive:
- Tax benefits for IRA holders
- Access to a wide variety of investment options to help holders meet their needs
- Opportunities to consolidate other qualified savings accounts into an IRA to help holders diversify their investments and savings
- Money that grows tax-deferred or tax-free depending on the type of IRA
- Penalty-free withdrawals available after age 59½
Advantages of an IRA
Unsure if an IRA is for you? These are the advantages that these accounts offer to those who want to save for retirement:
- Accessibility: Most people are eligible to open and contribute to these accounts as long as they or their spouses earn taxable income. Also, IRAs are so easy to set up.
- Tax-deferred growth: People who choose traditional IRAs won’t be required to pay taxes on their contributions or untaxed earnings until they start taking distributions, which must be done as soon as holders turn 73.
- Tax break in retirement: With a Roth IRA, people can contribute after-tax dollars, so withdrawals and earnings aren’t taxed. In other words, holders can take tax-free distributions during retirement.
- Ownership: With a 401(k), people are only participants because employers can change plans or set limits on investment options. However, IRA holders are account owners and have access to retirement benefits even if they switch jobs. Actually, they can roll over 401(k) funds into individual retirement accounts.
Diverse Types of IRAs
As mentioned, there are diverse IRA types, each has its own rules, eligibility criteria, tax benefits, and investment options. Below is more information about them.
Traditional IRA Explained
A traditional IRA allows holders to make pre-tax contributions since they’re often allowed to deduct some or all of their contributions from their taxable income in the year they’re made. However, withdrawals would be subject to income tax.
Roth IRA: An Overview
Roth IRAs are the opposite. Holders can fund these accounts with money they’ve already paid taxes on, which means they won’t be able to enjoy an immediate tax break. However, since they must pay taxes when making contributions, withdrawals are tax-free.
SEP IRA: Basics and Benefits
A SEP IRA, short for Simplified Employee Pension IRA, is tailored for self-employed individuals and small business owners, presenting substantially higher contribution limits compared to standard individual retirement accounts.
Exploring the basics and benefits of a SEP IRA reveals that holders can still enjoy equivalent tax advantages, but the distinctive feature lies in the fact that contributions are usually made by employers rather than employees. These are the two main benefits of SEP IRAs.
SIMPLE IRA: An Introduction
Also known as a Savings Incentive Match Plan for Employees, a SIMPLE IRA is an employer-sponsored retirement plan available to business owners and self-employed individuals.
Employees are allowed to defer their salaries to these accounts, choosing whether they want to make contributions. However, employers must contribute to these accounts as well, choosing one of the following options:
- Amounts equal to 2% of employees’ salaries
- Dollar-to-dollar matching contributions, limited to 3% of employees’ salaries
Rollover IRA: What You Need to Know
A rollover IRA is a type of retirement account that allows holders to move assets from an old employer-sponsored retirement plan to their IRAs, offering more investment options and lower fees.
By rolling over an old retirement account into an IRA, assets will preserve their tax-deferred status. Plus, owners won’t be required to pay taxes or penalties for early withdrawals when transferring their funds.
Inherited (Beneficiary) IRA: Key Points
An inherited IRA is an individual retirement account that a person can open if they inherit a plan with tax advantages, including those that are employer-sponsored, when the owner dies.
Individuals who inherit traditional or Roth IRAs cannot make tax-deductible contributions or IRA conversions. However, holders are required to take annual distributions and liquidate the accounts within 10 years after the death of the original owner. There are tax implications once this period ends.
Also known as Beneficiary IRAs, these accounts allow funds to remain tax-deferred. Typically, holders can withdraw money right away without being penalized.
Custodial (Minor) IRA: A Guide
A Custodial IRA is an alternative available to minors who receive an earned income. These accounts must be managed by the custodian, typically a parent, until the child turns 18 or 25, depending on their state.
Although these IRAs are held by custodians, all funds belong to children. That means they’re allowed to start saving money early for college or retirement. This account can be a traditional or Roth IRA.
Rules and Limits for IRA Contributions
There are rules and limits on how much a person can contribute to an individual retirement account each year. Find more details on this topic below.
IRA Contribution Limits: Current and Future
The contribution rules and limits are different for each type of account you can choose from.
Traditional IRA Contributions
Although this may be different under certain circumstances, most contributions to traditional IRAs are tax deductible. Money grows tax-deferred, but withdrawals made during retirement are taxed based on the holder’s ordinary income tax rate for that year.
In 2023, the maximum annual contribution to a traditional IRA was $6,500, increasing to $7,500 for those who were 50 or older (this is known as a catch-up contribution).
However, traditional IRA contribution limits are higher this year. People under 50 can contribute $7,000 to their accounts in 2024. The catch-up contribution is still $1,000 higher, as those who are 50 or older can contribute $8,000.
Roth IRA Contributions
Contributions to Roth IRAS aren’t tax-deductible the year they’re made. However, holders aren’t required to pay taxes on their investment gains.
Regarding Roth IRA contribution limits for 2024, the IRS has established that they’re the same for traditional IRAs. However, there are income limitations on such contributions. These are:
- $146,000 to $161,000 for single filers
- $230,000 to $240,000 for married couples filing joint taxes
In 2024, the maximum allowed contribution for a SEP IRA is $69,000.
The SIMPLE IRA contribution limit for employees is $16,000, with a catch-up amount of $3,500 for workers who are 50 or older.
Income Eligibility for IRA Contributions
How much you could contribute to an IRA depends on your household’s modified adjusted gross income (MAGI). A person cannot contribute more than their earned household income to a Roth IRA.
If the amount of money you earn in a year is less than the contribution limit, the contribution may be limited by that income. The same is true for those contributing to spousal IRAs. In that case, the contribution may be limited by the spouse’s income.
Traditional IRAs don’t have income-based limits, as you can make the maximum contribution regardless of the amount of money your household earned that year if it’s higher than the contribution limit.
However, your ability to deduct contributions made to a traditional IRA from your tax bills will depend on your or your spouse’s income or workplace retirement plan. These limits will be discussed later.
Additional IRA Rules: Wash-Sale Rule
Before exploring these rules, it’s important to define what a wash sale is. Essentially, it occurs when a person sells assets and repurchases or acquires them within a 30-day period.
The IRS has imposed the wash-sale rule to prevent investors from claiming tax deductions on losses of assets they still own. Therefore, any losses resulting from securities that are bought and sold within that 30-day period cannot be used to offset gains on tax returns.
Wash sale rules may apply in different scenarios, including a sale in a non-retirement account at a loss before purchasing an identical investment in an IRA.
Insights on Required Minimum Distributions (RMDs) in IRAs
According to the rules set by the IRS, an IRA owner is required to make withdrawals from their accounts each year after they reach a specific age. They’re known as required minimum distributions (RMDs).
As explained above, a required minimum distribution or RMD is a withdrawal that IRA account owners must start making each year as soon as they reach a certain age, which is 72 this year and is expected to be 75 in 2033.
The amount you should withdraw from your IRA depends on the size of your account and your life expectancy. Both are calculated based on criteria set by the IRS.
Guidelines for IRA Withdrawals
By understanding withdrawal procedures, IRA holders are required to comply with the rules mentioned above, making withdrawals from the year they reach 72. If you don’t take the minimum amount, you may face a penalty of 25% of the account balance.
Although it seems too expensive, it’s only half of the previous penalty. In some cases, if you take corrective action early, it can be reduced to only 10%.
Comparing IRA Options: An In-depth Analysis
Both an IRA and a 401(k) offer benefits to those who want to save for retirement. However, both options are different. You should evaluate each one in detail to choose the one that best suits your needs and expectations. Also, when comparing Roth and traditional IRAs, it’s important to understand tax regulations and contribution rules.
IRA vs. 401(k): Major Differences
There are major differences between IRA and 401k, such as the party that opens the account and making contributions.
While 401(k)s are offered through employees, IRAs can be opened by any individual with an earned income through an authorized institution, such as a bank or broker.
Investment options and contribution requirements are also different for both types of retirement plans. With an IRA, you can invest in many more products because the alternatives are numerous.
On the other hand, although investment options may be limited, 401(k)s allow higher annual contributions at $23,000 or $30,500 (for people aged 50 or older) in 2024.
Benefits of an Individual Retirement Account (IRA)
IRAs offer multiple benefits to holders, becoming a tax-advantaged way to save for your golden years.
This is a summary of the advantages that this type of retirement account offers:
- An IRA can reduce your tax bill in two scenarios: when you make contributions or when you take money from the account. This depends on the type you choose, whether it’s a traditional or Roth IRA.
- Investment gains can be tax deferred if you choose a traditional IRA or tax-free if you open a Roth IRA. In other words, with these accounts, contributing money to your retirement can help you avoid taxes on the money you’ll use during your golden years or reduce the taxes on your income for the years you contribute to your account.
- The Federal Deposit Insurance Corp (FDIC), an agency run by the government, insures IRAs. That means holders are protected in case the institution they open their account with fails. In most cases, the FDIC covers up to $250,000 in customer deposits per account if these funds are held at insured savings and loan associations or banks.
Guide to Opening an IRA
As long as they meet the eligibility criteria, anyone with an earned income can open and fund an IRA. As mentioned, this is so easy. This guide will walk you through the step-by-step process.
Steps to Open a Roth or Traditional IRA
Once you’re sure you’re eligible, the opening process for a Roth IRA is the following:
- Define what type of investor you are: If you want to do everything yourself, choose a brokerage, as this will allow you to select your own investments. However, if you want someone to pick an investment portfolio for you, you can open an account with a robo-advisor.
- Choose a financial firm: Where will you open your IRA? After deciding between a robo-advisory or a broker, you should pick a company that best suits your needs and preferences. Request information about investment minimums, explore available investment options, and check reviews from previous customers before making a choice.
- Choose a type of IRA to invest in: Do you think a Roth IRA is for you? Do you prefer the benefits offered by a traditional IRA? Evaluate each option in detail and pick the type of account that best fits your tax and financial situation.
- Open your account: To open your IRA, you must provide personal documentation to prove your identity and meet other financial requirements.
- Fund your account: Finally, you can complete the last step by selecting one of the three available options: transfer funds from a bank account, transfer assets from your IRA from a different firm to the new one, or roll over your 401(k) into the new account.
Top IRA Accounts in 2024
Choosing an IRA is an important personal decision, so you should evaluate each option available and pick the one that best fits your needs, preferences, or tax and financial situation.
However, these are some of the best brokers and robo-advisors you’ll find in 2024:
- Charles Schwab: Besides being investor-friendly, this corporation offers several investment options and handles all the primary brokerage functions needed for an IRA.
- Fidelity Investments: It’s one of the most recognized brokers, maintaining an excellent reputation over the years thanks to its friendly, knowledgeable, and helpful customer service, affordable services, solid trading platforms, and many investment products.
- Wealthfront: This robo-advisor has gained huge popularity in recent years thanks to its comprehensive services. It helps people build a retirement portfolio according to when they need the money, their goals, and their risk tolerance.
- Betterment: Serving people who are happy to let someone else manage their IRAs, this robo-advisor can build their portfolio from start to finish. Plus, it offers other benefits, such as automatic rebalancing and tax-loss harvesting.
Effective Management of Your IRA
IRAs can be excellent options for those who plan to invest and save money over the long term, especially for people who want to enjoy peace of mind and financial freedom during their golden years.
If you’re part of this group, you should know that you can boost your retirement savings by implementing some strategies.
Switching Your IRA: What to Know
Do you want to transfer your IRA? Most individuals planning to do this convert their current account to a Roth IRA. The process is so simple if you’re doing it with the same financial institution. In that case, you just have to request a conversion.
However, it’s important to understand that the transfer amount will be reported as income, which means you’ll likely be asked to pay taxes.
If you funded your account with after-tax contributions, which is possible through a non-deductible IRA, you may not be required to pay taxes upon conversion if you’ve had no gains. Sometimes, only a portion of the balance funded with pre-taxed money is subject to taxes.
Some people move their IRA balance into a Roth IRA in small portions each year if the conversion tax seems too big. However, all the options mentioned above are complex.
Many also choose an IRA rollover to move funds from their employer-sponsored plan to a new account because it offers several benefits, such as the following:
- Tax advantages
- Reduced costs
- Several investment options
However, you should always take other aspects into account to determine if it’s a good decision, as there will be fees involved in the process, and not all investment products included in 401(k)s are available through an IRA.
IRA Investment Strategies: Getting Started
Do you have an IRA and want to boost your nest egg? You can maximize your retirement savings by following these strategies:
- Start early, even if you can’t contribute the maximum amount in a year, as contributions can have a snowball effect and expand your nest egg over time even if they’re small
- Don’t make contributions to your IRA when you file your taxes, as you can miss out on growth opportunities or risk making the investment at a high point in the market.
- Make your contributions at the start of the tax year to allow your funds to compound for a longer period
- Think about your entire portfolio and avoid allocating all your money to just an IRA since these accounts will only be a part of your savings in the future
- Consider investing in easy products that offer diversification, including individual stocks
- Convert your existing traditional IRA to a Roth IRA if you think you’ll be in a higher tax bracket during your golden years
- Name a beneficiary so that the proceeds of your retirement account aren’t subject to probate fees or vulnerable to credit
Tax Implications of IRAs
IRAs can be excellent options for saving for retirement because they offer many tax benefits. However, there are some rules that you shouldn’t break if you don’t want to face severe consequences.
Understanding IRA Tax Benefits
As explained above, traditional IRAs offer an up-front tax deduction and tax-deferred growth, which means you won’t pay taxes on your contributions. Instead, you’ll be required to do so when you take distributions at age 3.
Roth IRAs are different but also offer some benefits. With these accounts, you can contribute after-tax money and enjoy a tax break when you’re in your golden years, as earnings and withdrawals won’t be taxed during retirement.
Tax Deductions for IRA Contributions
According to the IRS rules, you may be able to claim a deduction on your tax return for your IRA contributions. However, this only applies to traditional IRAs because Roth IRA contributions aren’t deductible.
If you or your spouse, if married, are covered by a retirement plan at work and your income exceeds a specific level, the deduction may be limited as follows:
- Traditional IRA contributions are fully deductible if you have a retirement plan at work and your MAGI is below $77,000.
- Such contributions are also deductible for those who have retirement plans at work, are married, and file jointly as long as their MAGI is below $123,000.
- This deductibility begins to phase out as the MAGI increases, settling at $123,000-$143,000 for married couples and $77,000-$87,000 for single taxpayers or heads of households.
- The income phase-out range is $230,000 to $240,000 for people who don’t have a workplace plan but are married to someone who does.
If you contribute an amount greater than your income or contribution limit according to your filing status, you’ll have to pay a penalty of 6% of the excess amount annually until you take corrective action.
Tax Penalties for Early IRA Withdrawals
Making early withdrawals from your IRA, specifically before age 59½, can also result in penalties, which are:
- A 10% additional tax penalty
- An ordinary income tax on the amount attributable to contributions and earnings that were previously deducted (some exceptions apply under certain conditions)
Planning for Retirement with an IRA
It’s never too late for a person to start saving for their golden years. While there are many options to choose from, IRAs offer tax benefits that can help holders maximize their savings and provide financial security during their retirement.
Role of an IRA in Retirement Planning
IRAs can be excellent tools for those who want to save money to enjoy aging without stress and financial burden. These accounts can give you peace of mind since they allow you to save money and even avoid taxes on your future withdrawals.
Additionally, individual retirement accounts are good options for those who don’t have a retirement plan at work or have one but don’t like investment options. These accounts are also ideal for people who have left their jobs and are afraid of forgetting about their 401(k) balance, so they prefer to roll over their funds to an IRA.
If you’ve maxed out the contribution limits of your workplace retirement plan but want to continue saving, you can save more in an IRA.
In simple terms, these accounts can be the perfect solution for those planning for their retirement because they want to be sure they have enough money for their golden years.
IRA and Social Security: A Comparison
Many companies offer defined-benefit pension plans to guarantee retirement income to workers. Federally funded Social Security is similar, as it provides guaranteed basic income to older Americans.
However, many people find themselves wondering if this is enough for their retirement or if they should open an IRA.
The truth is that both can be a source of income during retirement. Also, although many think otherwise, Social Security income can be subject to taxes just like IRA earnings and distributions.
However, you can have two. Withdrawals from your IRA won’t affect your Social Security benefit since the latter doesn’t count as interest from your savings and investments as earnings.
Frequently Asked Questions
What are the tax benefits of an IRA?
Depending on the type of IRA you choose, your income can grow tax-deferred or tax-free. With traditional IRAs, you won’t pay taxes on contributions but when you make withdrawals. Roth IRAs allow you to take a tax break during retirement because you’ll have to pay taxes when making contributions.
Can I contribute to both a 401(k) and an IRA?
Essentially, you can contribute to both an IRA and a 401(k). However, it’s important to respect contribution limits if you plan to participate in both retirement plans.
What happens to my IRA if I change jobs?
If you change jobs and don’t want to forget about the balance of your employer-sponsored retirement plan, you can roll over your existing account into your IRA.
Can I withdraw money from my IRA before retirement?
Since this account isn’t tied to your workplace, an IRA won’t be affected by your job switch.
What are the penalties for early withdrawal from an IRA?
If you make an early withdrawal from your IRA, you may be subject to a 10% penalty and state tax penalty.
Traditional and Roth IRAs can be really beneficial for those who want to save for retirement. However, it’s important to understand how these accounts work, their contribution limits, and any other related rules to avoid penalties and other issues.
If you have questions about your retirement plan, its benefits, or any other question related to this intricate topic, the best thing you can do is contact an expert and ask for advice.