Now is the time to start saving for your future! Whether your employer doesn’t offer a 401K or you’re just looking for other ways to save for your retirement, an Individual Retirement Account, or IRA, may be what you’re looking for. In this article, we are going to explore what an IRA is, the different types, and some best practices.
What is an IRA?
An IRA, short for Individual Retirement Account, is an investment fund that allows you to invest tax-deferred money towards your retirement. Similar to a 401K, there are annual contribution limits and tax implications depending on the type of IRA you utilize. However, unlike a 401K, you can open an IRA independent of your employer and you can self-direct how the funds are invested. Being that this is a retirement account, you should plan to not withdraw IRA funds until maturity at 59 ½ years old at the earliest, or you’ll incur penalties.
Cheat Sheet:
- Determine the best type of IRA for your financial situation
- Consider the value of fractional share investing when picking a broker
- Always try to save at least 10% of your income and put that money to work
- IRAs offer a great tax-advantaged investment vehicle for new and experienced investors, allowing for more flexibility than 401Ks
- IRAs provide added flexibility in self-directed investing, so do your research and understand what you are investing in.
- The earliest you can withdraw funds without a penalty is 59 ½-years-old.
Why Do I Care?
The first reason to care about an IRA is that retirement is expensive! We are about to be in the midst of a Baby Boomer retirement crisis! According to research conducted by the Insured Retirement Institute (IRI) 45% of Baby Boomers have NO retirement savings and 28% of those that do have LESS than $100,000. I know for a fact that in 20+ years $100,000 will not be enough to live off of, so it’s important to start now.
The second reason to care about an IRA is because of the added flexibility afforded to the investor. IRAs are self-directed investment vehicles, meaning that I get to pick exactly what I am investing in. Given the rise in “retail investors” or those of us that don’t professionally trade stocks for a living, an IRA is a great way to learn about investing. Given that you can’t touch the money until retirement, this is an opportunity to educate yourself on the stock market and other investment vehicles to build your wealth over time and help your IRA grow. There is increased risk because you may not be an experienced investor, but do your research and find an investment strategy that best fits your financial goals. We’ve outlined a high-level guide on How to Start Investing to be used as an easy primer to reference.
IRA At-A-Glance
These quick hits will be your cheat sheet to mastering your IRA strategy.
IRA vs. 401K – Which one is best for me?
If you’re following Lesson 1 of our How to Build Wealth Guide, then you’re already saving 10% of your earnings and likely investing it into your employer’s 401K (and hopefully collecting an employer match). Remember to always pay yourself 10% first no matter what!
However, 401Ks can be limiting and some employers don’t even offer them. So, how do you begin building wealth for your retirement? The answer is an IRA.
Ideally, you will be able to invest in both a 401K and an IRA. If your employer offers a 401K contribution match program, ALWAYS prioritize getting the employer match. This is free money and would be ludicrous to miss out on. After that, it is up to you to decide how to best contribute your 10+% of savings across retirement funds. Part of this process is to conduct a deep dive into your 401K portfolios that are available to you and see how they are performing against the market (S&P 500 and DOW Jones Index). Based on reviewing the available 401K portfolios’ performance, you can decide if you need to reallocate your 401K portfolio mix or begin using an IRA to invest your future retirement contributions.
As we consider both options, here are some of the key differences between 401Ks and IRAs:
Types of IRAs – Traditional, Roth, SEP, and SIMPLE
Now that we have a broad understanding of what an IRA is and some of its benefits, let’s dive into the different types.
Traditional IRA
A Traditional IRA is a tax-deferred investment account. This means that you may be able to deduct your contributions from this year’s taxes to gain the tax benefit now, but will be charged taxes on your principal contributions plus the earnings when you pull the money out during retirement.
Who Qualifies?
Traditional IRAs are great because anyone with a taxable income and under the age of 72 years old can open one. Some of the other types of IRAs we will discuss below have stricter restraints on who qualifies.
Tax implications
Depending on your personal and household income, you may be able to deduct your contributions from this year’s taxes. If you don’t have another retirement account through your employer, such as a 401K, you likely can deduct the full amount contributed. If you or your spouse have an employer-led retirement account, the math gets a little bit more complicated. In this scenario, based on your marital status and modified adjustable gross income (MAGI), your tax benefits would be as shown in the below chart. This gets a bit technical, so you can reference the IRS guidelines here.
Adapted from a chart found on NerdWallet.
Contribution limits
Traditional IRA contribution limits are pretty straightforward. For everyone under 50, you can contribute $6,000 per year. Those 50 and older can contribute $7,000 annually, utilizing a catch-up contribution bonus allowed by the IRS.
Roth IRA
A Roth Individual Retirement Account is a tax-advantaged retirement account, where you contribute post-tax dollars but will not incur taxes on the principal or earnings when you take withdrawals in retirement. Roth IRAs are great because you have the peace of mind in knowing that every dollar in your account will be what you get when withdrawing in the future.
Who Qualifies?
While Roth IRAs can be a powerful retirement investment vehicle, not everyone can contribute directly to one (see Backdoor Roth IRA below). There are specific earnings requirements that limit high-earners from contributing directly to a Roth IRA as outlined below:
Adapted from a chart found on NerdWallet.
Tax Implications
Since you are contributing post-tax dollars to a Roth IRA and the earnings grow tax-free, there is no taxable deduction towards your taxes.
Contribution Limits
For those that qualify, everyone under 50, you can contribute $6,000 per year. Those 50 and older can contribute $7,000 annually, utilizing a catch-up contribution bonus allowed by the IRS.
Withdrawal Flexibility
You should always strive to let your retirement accounts grow until you need them at the appropriate retirement age. However, Roth IRAs have some advantages when it comes to early withdrawals, or before you reach 59 ½. With Roth IRAs, you can withdraw contributions (not earnings) at any time tax- and penalty-free.
While the majority of early withdrawals on IRAs are still subject to a 10% penalty, if you have had your IRA in place for more than 5 years, you can avoid penalties if using it for the below reasons:
- The withdrawal is due to a disability
- Up to $10,000 for a first-time home purchase
- Beneficiary following a death
There are other scenarios in which this added flexibility would be helpful.
Backdoor Roth IRA
Is your modified adjustable gross income (MAGI) too high and restricting you from qualifying for a Roth IRA, but you would prefer to use a Roth? There’s good news! A common-known loophole in the IRS tax code allows a backdoor contribution into Roth IRAs.
The way it works is you open both Traditional and Roth IRAs. Then you contribute to the Traditional IRA, which has no income qualifiers. Before investing any of that money, convert it over to a Roth IRA and voilà, you now are the proud owner of a Roth IRA. As long as your income stays above the limits, this is the only way to contribute to a Roth IRA. You can work with your broker to navigate this transaction.
Traditional vs. Roth IRA
If you lookup Traditional vs. Roth IRA, you will get countless opinions and no clear winner on which is best for you. The reason for this is that it is a personal decision dependent on your financial and individual tax situation. The crux of it comes down to whether you think your tax bracket now is more favorable than it will be in the future when you withdraw funds. Since Traditional IRA/401K withdrawals are taxed as income, if the tax brackets are less favorable in 20 years (or whenever you hit retirement) you will end up paying more down the line than you would if you paid taxes now. The reverse scenario applies too.
Professor’s Opinion: I personally prefer Roth retirement accounts because, with the mounting national debt, I find it likely our taxes will be increased over time. There is also the irrational emotional impact of knowing that all my withdrawals from a Roth account are tax-free, relieving any stress around the unknown, future political climate. With that said, I personally hold both traditional and Roth 401Ks and elect for a Roth IRA. Do your own research and internal soul-searching and choose the type of IRA that best suits your personal financial situation.
SEP IRA
A Simplified Employee Pension, or SEP, is a retirement account available to self-employed or small-business owners. These are very appealing because they allow for higher annual contribution limits but do come with some specific rules.
Who Qualifies?
SEP is designed to allow self-employed and small-business owners a vehicle for retirement investments. Since this audience may not have access to a 401K plan, this allows them to still save for retirement, at an even more accelerated pace.
Tax Implications
A SEP is similar to a Traditional IRA in the sense that it is a tax-deferred account and all tax benefits apply to this year’s taxes. There is no Roth SEP, so all money invested is tax-deductible until you are ready to withdraw in retirement, where your principal and earnings will be taxed as income. You are able to deduct the lesser of your contributions or 25% of your compensation.
Contribution Limits
This is the most attractive element of a Simplified Employee Pension! Annually, you can contribute the lesser of 25% of compensation or $57,000. Compared to the $6,000 limit on regular IRAs and $19,500 limit on 401Ks, this provides qualified investors the opportunity to rapidly boost their retirement savings. There is no catch-up contribution for those that are over 50 years old.
Other Considerations
For small-business owners, they must contribute to a SEP IRA for your employees equal to the percentage of compensation that you are contributing for yourself. In this case, if you are contributing 10% of your own compensation into a SEP, you are required to also contribute 10% into a SEP for every one of your employees. Employees are eligible if they are 1) over 21 years old, 2) have worked for you three of the past five years, and 3) earned at least $600 from you in the last year. Employees will manage their own SEP IRAs just as they would a regular IRA.
SIMPLE IRA
A Savings Incentive Match Plan for Employees, also known as a SIMPLE IRA, is like a cross between a 401K and IRA for small businesses with under 100 employees.
Who Qualifies?
Employers are able to set up SIMPLE IRA plans for their employees if they are a small business under 100 employees. Employees manage the SIMPLE IRA just as they would a traditional IRA. This provides them the benefit of employer-supported contributions similar to 401Ks with the investment flexibility of an IRA.
Tax Implications
Similar to a Traditional IRA, SIMPLE IRA contributions are tax-deferred, meaning you can deduct your contributions against this year’s taxes but will have to pay taxes upon withdrawal on the principal plus earnings. An additional benefit to a SIMPLE IRA is that employers get a tax deduction for the contribution to employees’ retirement accounts.
Contribution limits
Similar to a 401K, employees elect how much of their paychecks they would like to contribute to a SIMPLE IRA. For employees under 50, they can contribute up to $13,500 and those over 50 can contribute $16,500. While better than a regular IRA, these contributions are still limiting when compared to the $19,500 limit for 401Ks.
Employers are required to contribute to employees’ SIMPLE IRA by providing matching contributions up to 3% of the employee’s pay or make a contribution equal to 2% of the employee’s compensation (not requiring a contribution from the employee). The employer contributions are immediately vested, a huge benefit for employees.
Withdrawal Age
As of 2020, you can pull out your retirement savings without penalty at 59 ½-years-old.
Since an IRA is a tax-deferred account, once you hit 72-years-old you are required to make annual required minimum distributions so the government can begin collecting on those sweet taxes. The IRS goes into detail on how to calculate these minimum required distributions, but we won’t bore you with that here.
Professor’s Tip: Always let your IRA reach maturity (59 ½ years). While there are cases where you desperately need to pull out money early, the early withdrawal penalty could massively undercut your ability to comfortably retire.
Compounding is Your Best Friend!
Like all long-term investments, you will benefit from the power of compounding interest. This principle revolves around gaining interest on your previous growth plus principal investments. This will have a huge impact, allowing for enormous growth potential if you stay vigilant in your investments and give your retirement savings enough time to grow. This is the key to Lesson 3 outlined in our How to Build Wealth article and another reason it is so important to start saving as early as possible.
How to open an IRA
Now that we are experts on the different types of IRAs, let’s get to investing and open our IRA. This is a simple process and I was able to open mine in under 10 minutes.
For a Traditional or Roth IRA, you will need to work with a broker to open an account. The broker is the institution that enables you to hold money in an investment account as well as actively make trades and investments. Some common online brokers are TD Ameritrade, Fidelity, Charles Schwabb, and Robinhood. They all have different platforms and user interfaces, so take a look at each and decide which is best for you.
Fidelity, Charles Schwabb, and Robinhood now offer fractional shares trading, where regardless of the stock price you can invest whatever dollar value you want into that company. This is a huge benefit to new investors because some stock prices are just too high to invest in given your limited capital. Imagine you really like Berkshire Hathaway (BRK.A) but can’t afford one share valued at $271,600 (as of 6/21/2020). Through fractional share buying, you can invest $100 into BRK.A and will incur the same percentage gains and losses that stock does.
Once you decide which broker you want to use, go to their website to open your Traditional or Roth IRA. All it takes is some basic financial information and a deposit. Within minutes, you’re on your way to building a better future for yourself.
Planning Is Key
Now that you are an IRA expert, check out this calculator to input your own personal finances to determine what money you will need to contribute over your lifetime to best set you up for financial stability in retirement.
Check out additional topics to make personal finance SLIGHTLY EDUCATIONAL on our Personal Finance page.
