Update: The deadline for making IRA contributions for tax year 2020 has been extended to May 17, 2021.
An individual retirement account, or IRA, is a savings account that is used to put away money for retirement, potentially grow funds through investment, and often get tax breaks.
There are a few different types of IRAs, but the two most common are traditional and Roth IRAs. While both types let you contribute up to $6,000 yearly (as of 2021), with an additional catch-up contribution of $1000 for those over age 50, one key difference is the way the two accounts are taxed: Traditional IRAs let you deduct your contributions up front and pay taxes on distributions when you retire, whereas Roth IRA contributions are not tax deductible, but you can withdraw money tax-free in retirement.
For most people, IRAs are worth learning more about—and potentially investing in. This guide offers insight into the different types of IRAs, which one might be right for you, and how to get started with an individual retirement account today.
Different Types of Individual Retirement Accounts
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 income taxes on the distributed amount.
Along with the upfront tax break, traditional IRAs also have the added benefit of allowing individuals to make contributions regardless of their income level.
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) . This means you’ll need to start making withdrawals by April 1 of the year after you celebrate your 72nd birthday, and by Dec. 31 each year 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.
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. In fact, 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
Roth IRAs are not subject to RMDs, so an 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: In 2021 the limit is $125,000 for single people (people earning more than $125,000 but less than $140,000 can contribute a reduced amount); for married people who file taxes jointly, the limit is $198,000 (or up to $208,000 to contribute a reduced amount).
A SIMPLE IRA, or 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 individuals themselves.
Any employer that has no more than 100 employees can establish a SIMPLE IRA plan for employees with $5,000 or more in compensation during the preceding calendar year.
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 must contribute to a SIMPLE IRA, and can do so in one of two ways:
• 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 $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 roll over your SIMPLE IRA within the first two years of participation into a plan that’s not another SIMPLE IRA.
SEP IRA stands for Simplified Employee Pension Individual Retirement Account. These plans are for business owners or self-employed individuals. 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.
Contribution limits are significantly higher than those for a traditional IRA. Annual contributions cannot exceed the lesser of $58,000 in 2021, or 25% of compensation, which is limited to $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, and can also have a traditional or Roth IRA account.
Benefits of Opening an IRA
The basic benefit of opening an IRA is that you are saving money for your future. Investing in retirement is an important financial move at any age. Beyond that, here are some popular benefits of opening an IRA:
• Anyone who earns 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). Non-income earning spouses can also open a spousal IRA.
• An IRA can supplement an employee plan. You could open an IRA to supplement your retirement plan at work, especially if you’ve already contributed the annual maximum.
• An IRA might be a good rollover vehicle. 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 consolidate all your accounts in one place.
• A SEP IRA might he useful if you’re self-employed. A SEP IRA may allow you to contribute more each year than the Roth or Traditional IRAs, depending on how much you earn.
Which Type of IRA Works for You?
There are many different types of IRAs and deciding which one is better for your particular financial landscape will depend on your individual circumstances and future plans. Here are some questions to ask yourself when deciding between different types of IRAs:
• 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.
• Thinking ahead, what do 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 invest in a traditional IRA, since you’ll pay more in taxes today than you would when you withdraw it later.
• Will you likely be at a higher tax bracket at retirement? That can easily happen as your career and income grow and you experience lifestyle inflation. In that case, a Roth IRA might give you the opportunity to save on taxes in the long run.
How Much Should You Contribute to an IRA?
If you can afford it, you could contribute up to the maximum limit in your IRA every year (including catch-up contributions if you qualify). Otherwise, it generally makes sense to contribute as much as you can, on a regular basis, so that it becomes a habit.
Until you’re well on track for retirement, many financial professionals recommend prioritizing IRA contributions over other big expenses, like saving for a down payment on a first or second home, or for your kids’ college education.
Any money you put away has the opportunity to grow over time, thanks to compound interest. Of course, everyone’s circumstances are different, so for specifics unique to your situation, it might help to talk to a financial advisor and/or a tax advisor.
How Can You Use 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. There are some ways an individual can use their IRA funds before hitting the age eligibility and without facing the 10% penalty, according to IRS rules, though early withdrawals are generally considered last resorts after all other options have been exhausted. These ways include:
• Permanent disability
• Higher education expenses
• Out-of-pocket medical expenses totaling more than 10% of adjusted gross income
• Qualified first-time homebuyers up to $10,000
• Health insurance premiums while unemployed
• IRS levy of the plan
• Military reservist called to duty
• Death of IRA’s owner
IRAs offer individuals an opportunity to save money for retirement in a tax-advantaged plan, without relying on an employer-sponsored plan like a 401(k). In addition, with a few different types of IRAs to choose from, it’s likely that many people will find an account that fits with their needs and goals.
IRAs are available from a wide range of investment brokerages, and typically you can choose between totally DIY options and automated investment products that can help you meet your retirement goals at a minimum effort.
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