IRA stands for individual retirement account. It’s a savings account that is used to put away money for retirement, potentially grow funds through investment, and often get tax breaks.
The most common types of IRAs are Traditional and Roth IRAs.
• Traditional IRAs let you deduct your contributions up front and pay taxes on distributions when you retire
• Roth IRAs don’t let you deduct contributions but allow you to withdraw money tax-free in retirement
You can only contribute the maximum amount to a Roth IRA if you make less than a certain amount of money. Not sure? Use SoFi’s IRA Calculator to get some quick and easy guidelines.
No matter where you are in your career, you’re probably well aware that you should be saving for retirement. But for investing newbies, the alphabet soup of retirement account options can be overwhelming.
But IRAs are worth learning more about—and potentially investing in. This guide offers some ideas that could help you learn what an IRA is and how to get started with a individual retirement account today.
Different Types of Individual Retirement Accounts
1. Traditional IRA
With a Traditional IRA, you get a tax break up front: The money you contribute to your IRA isn’t included in your taxable income the year you make the contribution. However, when it comes time to take the money out at retirement, you will pay taxes on the distributed amount and that will be deemed as income.
Along with the tax break up front, traditional IRAs also have the added benefit of allowing you to make contributions regardless of your income level—as long as you have earned income for the year and haven’t yet celebrated your 70.5th birthday. (Yes, half-birthdays are a thing in the world of the IRS.
That said, there are limits to your ability to deduct your contributions if you (or your spouse) are also covered by a retirement plan at work, like a 401(k).
Furthermore, Traditional IRAs are subject to required minimum distribution (RMDs) . That is, you can’t just let the money sit in your account to grow indefinitely. Rather, you’ll need to start making withdrawals by April 1 of the year after you celebrate your 70.5th birthday, and by Dec. 31 of years thereafter.
Generally, you’ll be subject to an additional 10% tax penalty if you make withdrawals from your traditional IRA before you reach the age of 59.5, though there are certain exceptions that may qualify you to take penalty-free distributions. These include certain medical expenses and those related to a disability, as well as other demonstrated circumstances of financial hardship.
2. Roth IRA
With a Roth IRA, on the other hand, you pay taxes on your contributions now in exchange for tax-free withdrawals at retirement later. While both Traditional and Roth IRAs are subject to early withdrawal penalties, Roth IRAs give you more flexibility to withdraw in special circumstances—and since you’ve already paid taxes on your contributions, you can take them out (without any investment-related growth) almost any time.
With a Roth IRA, you’ll be responsible to pay income taxes on the money you contribute to the fund today, but you’ll be able to make withdrawals tax-free once you reach age 59.5. Furthermore, because you’ve already paid taxes on the contributions themselves, you’re eligible to withdraw them at any time, and you can even make early withdrawals tax-free under certain qualified circumstances. These include:
• Making payments toward your first home
• Paying for qualified educational expenses
• Paying for certain medical expenses, including health insurance if you’re unemployed
Furthermore, Roth IRAs, unlike Traditional IRAs, are not subject to RMDs, which is to say the account owner can leave them to grow indefinitely throughout their lifetime. This makes them an excellent vehicle for passing on assets to heirs or loved ones after death, which can be attractive to those who have other funds supporting their retirement and plan on bequeathing money to their families.
However, with all these special exceptions come stricter limitations. You can only contribute to a Roth IRA if you fall under certain adjusted gross income levels: for 2019, $137,000 for single filers and $203,000 for married couples filing jointly. (If your income is close to these income levels but doesn’t quite meet it, you may be able to make reduced contributions. Again, check out the nifty IRA Calculator to find out more.)
3. SIMPLE IRA
A SIMPLE IRA or a Savings Incentive Match Plan for Employees allows small employers to offer tax-advantaged retirement plans. In a way they’re similar to a 401(k) since they’re offered by employers, as opposed to a Traditional IRA or Roth IRA, which are established by workers themselves.
Unlike 401(ks) however, SIMPLE IRAs are easier to set up. Any employer that has no more than 100 employees can establish a SIMPLE IRA plan. Employees with $5,000 or more in compensation during the preceding calendar year can participate.
Employee contribution limits for a SIMPLE IRA in 2020 and 2021 are $13,500 per year. People age 50 and older can make an additional $3,000 catch-up contribution.
Employers can make contributions via two methods:
• Match up to 3% of the employee’s pay. The amount can be reduced to as low as 1% in any 2 out of 5 years.
• Make non-elective contributions equal to 2% of the employee’s compensation based on a maximum salary of $285,000 in 2020 and $290,000 in 2021.
Contributions vest immediately, which means employees own the money in their SIMPLE IRA right away. Withdrawal rules are similar to those of a traditional IRA, except that the employee can’t withdraw for the first two years of participation in the program. Those who do withdraw in the first two years will be subject to an extra 15% early withdrawal penalty on top of the standard 10% penalty. That equals a total penalty of 25%.
This 25% penalty also applies if you rollover your SIMPLE IRA within the first two years of participation into a plan that’s not another SIMPLE IRA.
4. SEP IRA
SEP IRA stands for Simplified Employee Pension Individual Retirement Account. These plans are for business owners. Contribution limits are significantly higher than those for a Traditional IRA. A business of any size can elect these plans, and they are a good option for those who are self employed.
Anyone can participate in a SEP IRA as long as they are over 21 years of age, make at least $600 in a year, and have worked in three of the past five years. Annual contributions cannot exceed the lesser or $57,000 in 2020 and $58,000 in 2021, or 25% of compensation, which is limited to $285,000 in 2020 and $290,000 in 2021.That’s much higher than the $6,000 limit for traditional IRAs.
SEP IRAs are easy to set up and flexible. Individuals don’t have to commit to contributing to a SEP IRA every year. They can also be combined with a Traditional or Roth IRA.
Which Type of IRA Works For Me?
There are many different types of IRAs and deciding which one to open might seem confusing, and indeed, which is better for your particular financial landscape will depend on your individual plans and preferences. Here are some questions to ask when looking at different types of IRA and trying to choose one:
• Are you looking for a way to pass tax-free assets to your family? If so, a Roth IRA might be more attractive to you.
• Do you want to be able to access your contributions without paying penalties? Again, the Roth Individual Retirement Account may work better for you. But you need to make sure you’re eligible to open a Roth IRA.
• Are you busy paying down debts today and can benefit from every spare saved cent? Then the tax break offered by a traditional IRA might be appealing.
• Try to guess what you expect your tax income bracket to look like at retirement. If you think you’ll be in a lower bracket at retirement, it might make more sense to go with a Traditional IRA, since you’d pay more in taxes today than you would when you withdraw it later.
• If you think you’ll be at a higher tax bracket at retirement—which can easily happen as your career and income grow and you experience lifestyle inflation—a Roth IRA gives you the opportunity to save on taxes in the long run.
That said, all that depends on the tax code looking similar to how it looks today in however many years stand between you and retirement. Substantial edits to the tax code are made on occasion and may change the way taxes are assessed.
If you’re not sure which type of IRA will work best for you, it might help to talk to a financial specialist. The team at SoFi is happy to help you figure out which type of account will most suit you.
Benefits of Opening an IRA
• Anyone who is earning income can open an IRA. It’s a good option if you don’t have access to an employee-sponsored plan, such as a 401(k) or a 403(b).
• Almost everyone should be saving for retirement, and financial professionals generally recommend investing that cash so it has the opportunity to grow, rather than letting it sit around in a checking or savings account.
• You could also open an IRA to supplement your retirement plan at work, especially if you’ve already contributed the annual maximum.
• If you’re leaving your job, you could roll over funds from a 401(k) or 403(b) into an IRA. That may give you access to better investment options—not to mention consolidates all your accounts in one place.
• If you’re self-employed, you might want to look into a SEP IRA, which may allow you to contribute more each year than the Roth or Traditional IRAs, depending on how much you earn.
How Much Should I Contribute to an IRA?
If you’re still a ways out from retirement, and if you can afford it, you could contribute up to the maximum limit—that’s $6,000 for 2019—every year. (When you’re older than 50, you can contribute more.) Even if you can’t afford that, you might want to throw in as much as you can.
Until you’re well on track for retirement, most financial professionals recommend prioritizing IRA contributions over saving for a down payment or for your kids’ college education.
Anything you put away early on has the opportunity to grow over time, thanks to compound interest. Of course, everyone’s circumstances are different, so it always pays to talk to a financial advisor. And with all matters tax related, be sure to talk to your tax advisor so that you can see what is most appropriate for your unique circumstances.
How Could I Use My IRA Funds?
Early withdrawals of your IRA funds, prior to the age of 59.5, can trigger a 10% penalty tax. However, there are exceptions. Here are some of the ways an individual can use their IRA funds before hitting the age eligibility and without facing the 10% penalty, according to IRS rules:
1. Permanent disability
2. Higher education expenses
3. Out-of-pocket medical expenses
4. Qualified first-time homebuyers up to $10,000
5. Health insurance premiums while unemployed
6. IRS levy of the plan
7. Military reservist called to duty
8. Death of IRA’s owner
How Do I Open an IRA?
IRAs are available from a wide range of investment brokerages, and you can choose between totally DIY options and automated investment products that can help you meet your retirement goals at a minimum effort.
SoFi Invest® makes opening an IRA easy. Sign up for an investment account online with SoFi, in less than five minutes. And if you have any questions or want personalized advice, you can set up a call with a SoFi financial planner—absolutely complimentary.
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