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IRA Basics: Planning for the Time of Your Life

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Whether you're daydreaming about palm trees and frozen drinks or stressing about how to make payments on your home without a working income, preparing for the future doesn't have to take the spark out of living in the present.

An individual retirement account provides an easy way to fully enjoy where you are now even as you plan and save for what lies ahead.

What is an IRA?

An individual retirement account — commonly called an IRA — is a specialized account that allows you to save and invest for retirement, separate from any employer-sponsored retirement plan that you might participate in. Depending on the type of IRA you choose, your savings can grow on a tax-deferred or tax-free basis.

It's important to understand that an IRA is not an investment in and of itself. Think of an IRA as a channel that enables you to move money to and from a wide range of investments, including stocks, bonds, mutual funds, certificates of deposit (CDs), and other investment accounts.

Types of IRAs

There are four main types of IRAs, each with its own rules for eligibility, taxation, and withdrawals. They include:

Traditional

A traditional IRA allows you to steer pretax income to an account where your money can then be invested and grow without being taxed — until you make a withdrawal.

Roth

A Roth IRA lets you pay income tax on your money before you deposit it into an account where it can grow and later be withdrawn without additional taxes. 

SEP (Simplified Employee Pension)

SEP accounts enable businesses of any size, including self-employed individuals, to set up and make tax-deductible contributions to an IRA on behalf of employees.

SIMPLE (Savings Incentive Match Plan for Employees)

Designed for small companies not currently sponsoring a retirement plan, SIMPLE plans allow employees and employers to contribute to IRAs set up for workers.

The two most common and widely used IRAs are traditional and Roth accounts.

Think of an IRA as a channel that enables you to move money to and from a wide range of investments.

How Does an IRA Work?

At the core, all IRAs work the same way. Money placed in an account can be directed to an array of investments, enabling it to grow. Money is taxed before it enters the account or you make a withdrawal, but not while it remains in the account.

Infographic on the process of how an IRA works

Eligibility

Anyone who receives earned income can open and contribute to an IRA.

Contributions

Traditional and Roth IRAs allow you to contribute up to $6,000 annually until you turn 50 years old. After age 50, you can increase yearly savings to $7,000.

If you're self-employed, you can open an SEP account and contribute 25% of your annual compensation or $58,000, whichever is less. Or, you can participate in a SIMPLE IRA and put as much as $13,500 each year ($16,500 if you're over age 50) into your account as the employee, plus either a 2% fixed contribution or a 3% matching contribution since you're technically the employer as well.

Regardless of the type, you can make contributions to an IRA up until the tax deadline for each year. So, for instance, you could deposit money into your account on April 15, 2022, and still enjoy the tax benefits (if applicable) on your 2021 tax returns. 

Investments

Once you establish and begin paying into an IRA, you can choose from any of the stocks, bonds, funds, or other investment options available through your IRA provider.

Depending on your comfort level, you can manage your IRA investments personally or work with a financial advisor to help guide your strategy. You can also use automated investing, or a robo advisor, for a "set it and forget it" approach.

It's a good idea to vet your investments for growth potential and to make sure your money goes toward companies and initiatives that align with your particular ethics.

Withdrawals

You can begin making penalty-free withdrawals, or distributions, from any type of IRA at age 59½. Although you'll still be responsible for any taxes on the money withdrawn (if it wasn't taxed before entering the account), there are no legal restrictions on the amount of — or reasons for — distributions made at this point.

If you tap into a non-Roth IRA before age 59½, you'll have to pay ordinary income taxes on the amount you take, and the IRS will charge you an early withdrawal penalty of 10%.

There are, however, certain circumstances when penalties for early distributions may be waived. These exceptions include:

  • First-time home purchases
  • Educational expenses
  • Disability or death
  • Unreimbursed medical expenses
  • Birth or adoption expenses
  • Health insurance premiums during unemployment
  • Reservist distributions

Exclusions aside, you must start taking required minimum distributions (RMDs) from non-Roth IRAs at age 72, whether you need the money or not. Distribution amounts are determined by the balance of your account and your life expectancy.

Curious about wealth management?

Rollovers

IRAs allow you to move, or roll over, assets from one retirement plan to another retirement account without paying taxes or early withdrawal penalties on the transaction. The contribution to the second retirement account is called a rollover contribution, and you generally have 60 days from when you receive money from the first account to deposit it into the IRA.

Rollover IRAs are most often used to transfer funds from an old employer-sponsored retirement plan into an account where your money can continue to grow tax-deferred. In many cases, you can later move money from a rollover IRA into another employer-sponsored retirement plan if you need or want to do so.

Traditional IRA vs. Roth IRA

With a Roth IRA, you pay taxes on the front end before money goes into the account. A traditional IRA, on the other hand, taxes contributions when they're withdrawn.

Other notable differences include:

Tax Implications

Generally, contributions to a traditional IRA can be deducted on your federal and state taxes for the year the deposits were made. Roth IRA contributions aren't tax deductible.

Income Restrictions

You can open and contribute to a traditional IRA regardless of your income. On the other hand you can only participate in a Roth IRA if you earn less than $140,000 ($208,000 for married couples).

Distribution Rules

Roth accounts, unlike traditional IRAs, aren't subject to RMDs. So, you can keep money in a Roth IRA indefinitely and even leave it untouched to pass to a beneficiary upon your death.

Early Withdrawal Penalties

Under most circumstances, you'll face a penalty for withdrawing money from a traditional IRA prior to age 59½. With a Roth IRA, you can take out up to the full amount of your contributions at any time without penalty. However, you will be penalized for withdrawing any earnings generated by the account before you reach age 59½.

Contribution Limit Taxable Period Tax Deductible Income Restriction Withdrawal Penalty Required Distribution
Traditional $6,000 annually* Upon Withdrawal Yes No Yes Yes
Roth $6,000 annually* Before Contribution No Yes No No
SEP 25% of yearly income or $58,000** Upon Withdrawal Yes No Yes Yes
SIMPLE $13,500 annally plus 2-3%** Upon Withdrawal Yes No Yes Yes

*Contribution limit increases to $7,000 annually after age 50.

**For self-employed individuals.

Should I Choose a Traditional IRA or Roth IRA?

There's no right or wrong choice when deciding between a traditional or Roth IRA. There are, however, several factors to bear in mind:

  • Income: If you earn more than the annual threshold for Roth IRAs ($140,000 for individuals or $208,000 for married couples), a traditional account is the only way to go.
  • Current Tax Rate: If your current tax rate is higher than you anticipate it will be when you retire, opt for a traditional IRA. You'll avoid paying taxes on contributions now and benefit from being in a lower tax bracket when you start making withdrawals.
  • Projected Tax Bracket: If you expect to have more tax obligations when you reach retirement, consider starting a Roth IRA. The tax-free withdrawals will be a welcome relief when you're paying taxes on other accounts once you've stopped working.
  • Access to Funds: If you think you might need or want access to money you've set aside before you reach retirement, a Roth IRA is the way to go. These accounts allow you to withdraw up to the full amount of the tax-paid contributions you made (but not earnings) at any point.

While you may not have answers for every "if," an earnest look at where you are and where you expect (or hope) to eventually be can help you choose an IRA that suits your needs.

How to Start an IRA

IRAs are available from most credit unions and banks, as well as traditional and online brokers, mutual fund providers, and other investment companies. As you research accounts and providers, be sure to consider:

  • Costs: Maintenance fees, commissions, and other charges collectively chip away at your retirement savings, so look for IRAs that have low transaction fees and few, if any, additional costs.  
  • Service: If you don't feel confident managing your own retirement account and selecting investments, opt for a full-service provider rather than a low-cost or automated brokerage.
  • Investments: Search for a well-established company whose IRAs provide access to funds with proven track records for performance and returns.

After finding an account and provider that you're comfortable with, the process of opening an IRA is pretty straightforward.

  1. Complete an application. Whether applying online or in person, you'll fill out paperwork and provide some personal information, including:
    • Name
    • Address
    • Date of birth
    • Social Security number
    • Employer information
  2. Fund the account. Although the IRS doesn't require a minimum deposit to start an IRA, some account administrators do. Take this into consideration when weighing your account options.
  3. Regardless of the amount, you can fund your IRA with a check or transfer from your regular savings or checking account. You can also roll over funds from a 401(k) or other existing retirement plan.

  4. Select your investments. Once your account is open and funded, you can choose to invest in stocks, bonds, mutual funds, certificates, or a variety of other vehicles — or any combination thereof. Base this decision on your financial situation, retirement goals, and risk tolerance. Risk tolerance refers to how much you can afford to ride the market. For instance, if your investments take a dip, can you afford to wait it out while the market recovers?

IRA FAQs

When it comes to choosing and using an IRA, you're going to have questions. Here are answers to some of the most common ones.  

What's the difference between an IRA and a 401(k)?

The main difference between 401(k)s and IRAs is that 401(k) plans are established by employers on behalf of their employees, whereas individuals (i.e., you) open IRAs for themselves or others (typically a spouse or dependent) through credit unions, banks, brokers, or other financial institutions.

In addition, IRAs generally offer more investment options, while 401(k)s allow higher annual contributions (up to $19,500 annually). Employers can also make contributions to 401(k)s up to certain limits, regardless of how much or little the employee contributes.

Can you contribute to an IRA and a 401(k) at the same time?

Yes, you can contribute to an IRA and a 401(k) at the same time. In fact, it's a good idea to participate in both, particularly if your employer matches a percentage of what you contribute to the 401(k).

How much money do you need to start an IRA?

Minimum investments vary by IRA providers (some are as low as $0), but it's better to contribute as much as your budget allows up to the maximum permitted ($6,000 annually if under age 50 or $7,000 after that). This enables you to effectively save for retirement while enjoying any tax benefits that may apply.

Can you take money out of an IRA?

Yes, you can take money out of an IRA at any time for any reason. However, if you withdraw funds from your account before age 59½, you may be subject to an early withdrawal penalty, depending on the type of IRA you have and the reason for the distribution.

Are there age limits on IRAs?

No, the SECURE Act of 2019 eliminated the age limit that previously prohibited people from making contributions after they reached age 70½.

Can you make IRA contributions for a spouse?

Yes, the IRS allows a working spouse to contribute to their non-working spouse's traditional or Roth IRA up to the maximum annual contribution — provided they file a joint tax return.

How do IRA contributions impact taxes?

Contributions to a traditional IRA can be deducted on your federal and state taxes for the year the deposits were made. This, in turn, lowers your adjusted gross income (AGI), which may make you eligible for other tax savings and incentives.

Can you move money from a traditional IRA to a Roth IRA?

Yes, if you have a traditional IRA, you can convert it to a Roth account. You'll have to pay federal income taxes on the amount you move, and you may be subject to state income taxes.

Breaking it Down

Timing, as the saying goes, is everything. By leveraging the power of IRAs, you can put away money for post-career life, save on taxes, and access numerous investment options that might not be available through other retirement plans.

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