Saving for retirement is complicated, and if you’re like most, you were never taught how to handle your money in school. So, if you’re not totally sure what an IRA is, how it works, or if you should have one, there’s no need to hide it.
In fact, that’s where we come in. Read on for a run-down of IRA basics, so you can feel more secure about saving for your future.
1. How is an IRA different from a 401(k)?
Both IRAs and 401(k)s are tax-advantaged ways to grow money for retirement, but an IRA, which stands for individual retirement account, is “an independent account that you, as an individual, are initiating or creating,” says Katy Song, a SoFi Certified Financial Planner. “A 401(k) comes through your employer and has to be funded through payroll contributions.”
So, if you have extra money that’s sitting in a checking, savings, or investment account, you can’t just throw that into a 401(k). But you might be able to put some of that cash into an Individual Retirement Account. That’s one advantage of an IRA.
On the other hand, you can contribute more to a 401(k). As of 2018 , you can put up to $18,500 into a 401(k) each year, whereas you can toss in a maximum of only $5,500 into a Traditional or Roth IRA (or a combination of the two) each year. When you’re 50 or older, those maximums go up slightly.
(Though, note that there are income limits and may be other considerations, so you should talk to your tax advisor before making a contribution.) And sometimes employers will offer a 401(k) “match,” which means that they put additional money into your retirement account. This is typically done as a percentage of contributions with a cap, such as “100% match up to 3% of your salary”. Those are some advantages of a 401(k).
But here’s some good news: You can have both. If you have access to an employer-sponsored 401(k), most financial planners recommend contributing as much as possible there, then supplementing with an IRA if you can. And if you don’t have a 401(k)? An IRA is a must, says Song. If you just put money into a savings or investment account, you won’t get any tax deferral advantages.
2. Traditional vs. Roth—how do they work?
The three most common types are Traditional, Roth, and Rollover IRAs. (There are other kinds, like SEP and SIMPLE IRAs, but those are geared toward people who are self-employed or running small businesses. If that applies to you, read more about SEP IRAs.)
With a Traditional IRA, you get a tax deduction when you contribute. With a Roth, you don’t get a tax deduction when you contribute but your money grows tax-free. And a Rollover IRA is where you should put any money that’s sitting in an old employer plan—like a 401(k) from a past job.
Note: Many financial companies may not allow you to contribute annually to a Rollover IRA, says Song, but it’s still a worthwhile move.
3. Which kind of IRA is best for me?
If you have money sitting in a 401(k) from an old job, you’ll likely want to move that money to a Rollover IRA. Even if your employer paid the 401(k) fees, many stop doing that and pass them on to you when you leave. Companies can merge or go out of business. If that happens it can be very hard to roll over your money. If you’ve never changed jobs, then you probably don’t need a Rollover IRA.
“Many people have one Rollover IRA and then either a Traditional or Roth IRA,” says Song. To figure out whether a Traditional or a Roth IRA is best for you, think about your current tax bracket and what tax bracket you’re likely to be in when you retire. (A SoFi financial advisor can help you think through this.)
“If you think you’re not going to earn any income in retirement and you’re going to have really low taxes, you want to take the deduction today and open a Traditional IRA. But if you’re in a low tax bracket today and you’re not paying a whole lot of taxes and you don’t need more tax deductions, you would opt for the Roth IRA,” says Song.
You could, technically, open both and contribute, say, $2,500 to a Traditional and $3,000 to a Roth each year, but Song isn’t a big fan of that approach. “I think it gets confusing,” she says.
4. How much should I put into an IRA?
Your goal should be to try to hit that maximum of $5,500 per year, which is the equivalent of contributing about $459 per month. If you can’t afford that, don’t worry. Just get as close to that number as you can. “Try to make an annual contribution, no matter what the amount is, just to start early in life and get in the habit and let the power of compounding be on your side,” says Song.
5. When should I make IRA contributions?
Song recommends setting up an automatic contribution once a month that takes money from your checking or savings account and puts it directly into your IRA. Then, you never have to worry about forgetting to contribute, and you won’t miss (or spend) money that you never see. Use our IRA calculator to help determine which contributions you can make.
You don’t have to contribute monthly—the frequency is totally up to you, and many people contribute once annually, after they receive a year-end bonus, for example, or before the annual deadline of when taxes are due in April of the following year. But consider this: The sooner you put money into the IRA, the more time it has in the market. No, investing isn’t without risk, but more time in the market means more time to (hopefully) grow.
Also, it’s often less risky to spread out your investments. “What if you contribute every April, but the market is super hot in April and you buy at the peak price?” asks Song. By spreading out your contributions, you’re doing something financial analysts call “dollar-cost averaging.” While you’re not totally eliminating the risk of loss, you are averaging out the cost of the purchases, which may save a little money in the process.
6. Is there anyone who won’t benefit as much?
Yes. If you’re a high earner, pay attention to this part.
• Traditional IRAs: Anyone can open a Traditional IRA and contribute to it, but in some cases, Traditional IRA contributions may not be considered tax-deductible. For instance, if you’re single and you’re covered by a workplace retirement plan like a 401(k), your Traditional IRA tax deduction starts to become reduced when your modified adjusted gross income (MAGI)—your gross income minus what you put into your 401(k) and medical premiums—is $63,000.
For married couples filing jointly, where the spouse who makes the Traditional IRA contribution is covered by a workplace retirement plan, the deduction starts to go away when that person’s MAGI is $101,000. For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction starts to phase out if the couple’s MAGI is $189,000.
•Roth IRAs: You can open a Roth IRA and contribute the maximum to it only if your income is below a certain level. If you’re single, the phase-out begins if your MAGI is $120,000. If you’re married and filing jointly, the phase-out begins if your MAGI is $189,000.
If you fall into one of these categories, what should you do? If you or your spouse has a 401(k), you can start by trying to max out that contribution each year. Then talk to a financial advisor to see whether that’s enough to keep you on track toward your retirement goal or if opening an IRA on top of that would help. In most cases, Song still recommends both.
7. How do I open an IRA?
Like everything else these days, do it online! Though all the IRA rules are complicated, the process of opening one up with SoFi takes just a few minutes.
And if you have any questions about which account is right for you, SoFi financial advisors are available to help, absolutely complimentary.
“The great thing is we have financial advisors who are there to walk you through every step of it. So whether it’s the first time you’re opening an account, or you have accounts that you want to consolidate, we take the guesswork out and do most of the work for you,” says Song.
SoFi Wealth, LLC does not render tax or legal advice. Individual circumstances are unique and we recommend that you consult with a qualified tax advisor for your specific needs.
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