Update: The deadline for making IRA contributions for tax year 2020 has been extended to May 17, 2021.
Is it possible to lose money by investing in an Individual Retirement Account (IRA)? Investments, including some types of retirement accounts, can at times lose money. Typical reasons for losses might span things like: negative market movements, early-withdrawal penalties, lack of diversified assets, or not enough time for your investments to compound.
But, because retirement funds are generally long-term investments, the more years one invests in a diversified IRA, the more time that retirement account has to accrue value—making them less prone, in the long arc, to short-term dips in the markets.
So, what exactly is an IRA? An IRA is a type of tax-advantaged investment account that may help individuals plan and save for retirement. IRAs permit a wide range of investments, but—as with any volatile investment—individuals might lose money in an IRA, if their investments are dinged by market highs and lows.
Still, IRAs can offer investors specific tax advantages that could help them to save faster than with traditional brokerage accounts (which can get taxed as income). What’s more, there are strategies investors may want to adopt to limit the chances that a low-performing investment could sink the rest of their portfolio. Here’s a look at the different types of IRAs, the benefits they can offer to investors, and some tips for diversifying one’s IRA portfolio.
What Are the Different Types of IRA Accounts?
IRA stands for individual retirement arrangement. It provides one way to save for retirement through investing, all while offering some tax benefits. The two most common types of IRAs are traditional and Roth IRAs. But, if an investor works for themselves or owns a small business, they might also establish an SEP (aka Simplified Employee Pension) or SIMPLE IRA (aka Savings Incentive Match Plan for Employees).
Below is an overview of the most common IRA types:
A Traditional IRA is an easy-to open retirement account that allows individuals to contribute and invest money pre-tax. Money inside a traditional IRA grows tax-deferred, and it’s only subject to income tax once it gets withdrawn. Money in the account can grow faster than it otherwise might, because the IRS isn’t assessing any taxes while it’s invested. Contributions to a traditional IRA are typically tax deductible, and lower an individual’s taxable income in the year they contribute.
Traditional IRAs are subject to contribution limits. In 2020 , for example, individuals could contribute up to $6,000 per year to their traditional IRA (or $7,000 if aged 50 or older and making catch-up contributions).
For this sort of account, when individuals reach a certain age, they must start taking required minimum distributions (RMDs). Those who turned 70 1/2 before January 1, 2020, must take their RMDs at age 70 1/2. Anyone who turns 70 1/2 after this date, on the other hand, must start taking RMDs at age 72.
RMDs are generally calculated by taking the IRA account balance and dividing it by a life expectancy factor determined by the IRS. This factor is published in IRS Publication 590-B .
Saving in an IRA means an individual is, essentially, locking their money up until they reach age 59 1/2. Withdrawals from a traditional IRA before then are usually subject to income tax and a 10% early withdrawal penalty. There are some hardship exemptions to this rule, however—such as using a set amount of IRA funds to pay a medical insurance premium after an individual loses their job.
The main difference between a Roth IRA and a traditional IRA is that contributions to a Roth are made with after-tax money, and contributions are not deductible. Nonetheless, invested money can then grow tax-free inside the Roth IRA account and is not, typically, subject to income tax when withdrawals are made after age 59 1/2.
Roth IRAs are subject to the same contribution limits as traditional IRAs, but the amount an individual can contribute may be limited based on filing status or income levels. Moreover, Roth beneficiaries are not legally required to withdraw funds at a specific age. So, unlike with traditional IRAs, individuals can contribute to a Roth after age 70 1/2.
Additionally, Roth withdrawal rules are a bit more flexible than those associated with a traditional IRA. Individuals can withdraw contributions to their Roth IRAs, for example, at any time without having to pay income or a penalty free. However, they may pay taxes and a 10% penalty on earnings they withdraw before age 59 1/2.
A simplified employee pension, or SEP IRA, provides small business owners and self-employed people with an easy way to contribute to their employees’ or own retirement plans. Contribution limits are significantly larger than traditional and Roth IRAs. In 2020 , employers can contribute an amount up to 25% of their employees’ compensations or $57,000 each year, whichever is less. The amount of employee compensation that can be used to calculate the 25% is limited to $285,000 in 2020.
If an individual is the owner of the business and makes contributions for themselves, employee contributions must be the same proportion of their salary.
When it comes to RMDs and early withdrawal penalties, SEP IRAs follow the same rules as traditional IRAs. (However, in certain situations, this penalty may be waived).
A Savings Incentive Match Plan for employees, or SIMPLE IRA, is a traditional IRA that both employees and employers can contribute to. They are, typically, available to any small business with 100 employees (or fewer). Employers are required to contribute to the plan each year by making a 3% matching contribution , or a 2% nonelective contribution, which must be made even if the employee doesn’t contribute anything to the account. This 2% contribution can be calculated on no more than $285,000 of employee compensation.
Employees can contribute up to $13,500 to their SIMPLE IRA in 2020, and they can make catch-up contributions of $3,000 after age 50, if their plan allows it.
As with other traditional IRAs, SIMPLE plans have age-dictated RMDs and early withdrawals are subject to income tax and a 10% penalty. The early withdrawal penalty increases to 25% for withdrawals made during the first two years of participation in a plan. (There are, however, certain exemptions recognized by the IRS that would allow a SIMPLE IRA beneficiary not to pay additional taxes.)
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Limiting Risk in IRAs
One thing all of the IRAs above have in common is they allow the individuals who hold them flexibility in investment options—including mutual funds, property, stocks, bonds, ETFs, and annuities. As a result, IRA investors can have a big say in what their retirement portfolio will look like. And while it is possible that their portfolio may lose money, there are ways to manage that risk. By contrast, 401(k)s often offer limited investment options, such as a handful of mutual funds or target date funds.
Diversification is chief among an investor’s risk management tools. A diversification strategy means spreading money across multiple asset classes, such as stocks and bonds. A portfolio can be further diversified within each asset class. For example, diverse stock holdings might include stocks from companies of different sizes, sectors, and geographical locations.
Why go through all this trouble? Diversification helps minimize the effects market risk can have on an investor’s portfolio.
There are two main types of market risk. Systematic risk is caused by factors that have a broad impact on the market as a whole, such as inflation or a global pandemic. Unfortunately, there’s not much an investor can do about this sort of risk.
Unsystematic risks, on the hand, are limited to individual companies, industries, or geographies. For instance, a workers’ strike at a factory could halt production and drag down an automaker’s stock price.
Diversification helps mitigate unsystematic risk. So, if an individual holds stocks in hundreds of different companies, one poorly performing company may have minimal negative impact on their portfolio’s performance.
While diversification cannot prevent the risk of loss entirely, it may help individuals’ portfolios less vulnerable to market volatility.
Time Horizon for Investments
Some investors might want to consider their time horizon in an effort to minimize portfolio losses that can occur at inopportune times. A time horizon is the amount of time an investor anticipates holding an investment until they want the money back.
When an investor is young, they may choose to hold riskier investments, such as stocks in their portfolio. Stocks can offer more opportunity for growth, but—on the flip side—stocks can also suffer big drops in value.
Investors who are many years away from a financial goal, such as retirement, may opt to hold more stocks to take advantage of their growth potential. With many years to go before they need to tap their investments, these investors have time to ride out the market’s swings.
As investors approach their financial goals, the risk of stock market volatility may no longer be worth the potential for gain. An investor closer to retirement, for example, may want to hold fewer risky investments and select more conservative options—such as bonds.
A more conservative allocation aims to help reduce the overall chance that a portfolio could experience significant losses just when an investor needs their money most.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.