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So, What Exactly Is an IRA?

March 03, 2020 · 6 minute read

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So, What Exactly Is an IRA?

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 why and how to get started today.

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, while 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.

Differences Between Traditional and Roth IRAs

The most basic difference between the Traditional IRA and the Roth IRA is when you’re taxed—because if there’s one thing that’s true in this world, it’s that you can’t escape death or taxes.

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 the will be deemed as income.

With a Roth IRA, on the other hand, you pay taxes on your contributions now in exchange for tax-free withdrawals at retirement later. However, there are some other important differences between these two types of retirement accounts to take into account.

For example, 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.

Let’s dig into the differences between these two types of IRAs so you can figure out which version might work better for your needs.

Traditional IRAs

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 distributions (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.

Roth IRAs

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.)

Which Type of IRA Works For Me?

Deciding which of these two types of IRAs to open might seem confusing, and indeed, which is better for your particular financial landscape will depend on your individual plans and preferences.

For example, if you’re looking for a way to pass tax-free assets to your family, or you want to be able to access your contributions without paying penalties, a Roth might be more attractive. That is, of course, if you’re eligible to open a Roth IRA.

On the other hand, if you’re busy paying down debts today and can benefit from every spare saved cent, the tax break offered by a traditional IRA might be appealing.

One common suggestion offered by some financial advisors? 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.

On the other hand, 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 behoove you.

Why Should I Open an IRA?

Anyone who is earning income can open an IRA. It’s a no-brainer 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, 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?

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?

If you’re decades away from retirement, you don’t want to let your retirement savings sit in cash or money-market accounts. Yes, they’re low risk, but you might pass on an opportunity to grow your savings through investment. The easiest way to invest is to choose a “target date fund,” which is a mutual fund geared toward the year you plan to retire.

These will automatically switch up your mix of stocks, bonds, and other investments so that you’re more aggressive when you’re younger and more conservative when you get closer to retirement. Try to choose funds that have an expense ratio—or annual fee—below around 0.4%. Not sure if you are on track for retirement? Use a retirement calculator to figure out where you stand.

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.

Want to find out how smart investments can help you meet your long-term financial goals? Learn more about SoFi Invest today.

External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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.
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