What is an IRA?
IRA, which stands for Individual Retirement Account, is like a special savings plan for your retirement. There are different kinds of IRAs, but they all give you a tax advantage when you save money for your later years using the money you earn.
These various types of IRAs have different rules about how much you can put in, and some have income restrictions. For instance, the two most common IRAs, the traditional and Roth IRAs, allow you to contribute up to $6,000 in 2022 and $6,500 in 2023. But if you’re 50 or older, you can add an extra $1,000 each year, making it a maximum of $7,000 in 2022 and $7,500 in 2023.
You can open an IRA with different kinds of financial institutions, like online brokers, regular banks, robo-advisors, or investment firms. After you’ve put your money into the IRA, you can use it to buy different things like stocks, bonds, or mutual funds, depending on the rules of the institution you choose.
Types of IRAs
There are various types of IRAs to choose from, each with its unique features. Some well-known IRA options include:
Traditional IRAs
Traditional IRAs are like a savings option for retirement where you put money from your paycheck before taxes. This money can grow without being taxed until you take it out later, and you might even get a tax break for putting it in. Almost anyone can use this type of IRA, but there are a few rules.
In 2022, you can put up to $6,000 in your traditional IRA, or $7,000 if you’re 50 or older. These limits will go up to $6,500 and $7,500 in 2023 for those who are at least 50. Keep in mind, these are the total amounts you can contribute in a year, whether it’s to a traditional or Roth IRA. If you and your spouse don’t have a retirement plan through work, you can deduct the full contribution amount from your taxes. But if you or your spouse do have a work retirement plan, the amount you can deduct starts to phase out at certain income levels in 2023:
- If you file taxes on your own, it starts to phase out at $73,000 (up to $68,000 in 2022).
- If you’re married and both of you have a work retirement plan, it starts to phase out at $218,000 (up to $204,000 in 2022).
- If you’re married and only one of you has a work retirement plan, it starts to phase out at $116,000 (up to $109,000 in 2022).
A traditional IRA has some great advantages, especially if you think you’ll be in a lower tax bracket when you retire. If you expect your taxes to be lower later, it’s a smart move to take the tax benefits now when they’re more valuable and pay taxes on the money you take out when your tax rate is lower.
Roth IRAs
The big difference between a traditional IRA and a Roth IRA is how you handle your money for taxes. With a Roth IRA, you put in money that you’ve already paid taxes on, so you don’t get a tax break right away. But the cool thing is that this money can grow without any taxes, and when you take it out in retirement, you don’t have to pay taxes on it either. Both Roth and traditional IRAs have the same yearly contribution limits: $6,000 in 2022 or $7,000 if you’re 50 or older. In 2023, it’s $6,500 or $7,500 if you’re 50 or older. But here’s the catch with Roth IRAs – they have income limits on who can use them.
If you think your taxes will go up when you retire, a Roth IRA might be a smart choice. That’s because you won’t have to pay any taxes on the money you take out later, even if your tax rate is higher.
And if you’re worried about making too much money and having your Social Security benefits taxed, a Roth IRA can help with that too. That’s because the money you take out from a Roth IRA doesn’t count when they decide if your Social Security is taxable or not.
SEP IRAs
A Simplified Employee Pension IRA, or SEP IRA for short, is a retirement plan that’s great for small business owners or folks who work for themselves. With this type of account, only employers (including self-employed individuals) can put money into it.
Now, here’s how it works: In 2023, you can contribute up to 25% of your employee compensation or a maximum of $66,000. This amount was $61,000 in 2021. The cool thing is, there are no income limits that stop you from putting money into a SEP IRA. Plus, the money you put in is tax-deductible for the year you contribute it.
SEP IRAs are awesome if you’re your own boss or you run a small business and want to save a lot for retirement. But here’s the catch: If you have employees who are eligible to join the plan, you have to contribute the same percentage of their pay as you do for yourself. So, if you have a big team, you might end up putting a substantial amount into their retirement accounts if you want to max out your own contributions.
SIMPLE IRAs
Just like SEP IRAs, small business owners and self-employed folks can also set up something called a SIMPLE IRA. But here’s the twist: with SIMPLE IRAs, both the bosses and the employees can put money into it. In 2023, regular employees can contribute up to $15,500 (it was $14,000 in 2022). If you’re 50 or older, you can add an extra $3,500 in 2023 (it was $3,000 in 2022) on top of that, but only if your plan allows it. And here’s the good news: there are no income limits stopping you from contributing.
Now, here’s where it’s a bit different from SEP IRAs: even though the total amount you can put in might be lower, you have more options for how you want to divvy it up among your employees.
Rollover IRAs
A rollover IRA is like a special type of savings account where you can put money from another retirement account. Let’s say you had a 401(k) from your old job, and you decided to leave that job. You can take the money you had in your 401(k) and move it into this rollover IRA.
The cool thing is, you don’t have to open a brand-new “rollover IRA” just for this. You can use an existing IRA you already have. But there’s a catch – moving money like this can sometimes affect your taxes.
If you want to avoid owing taxes right away, it’s best to move your money into the same kind of account you had before. For example, if you had a regular 401(k), you can roll it over into a regular IRA, or if you had a Roth 401(k), you can roll it into a Roth IRA.
Spousal IRAs
A spousal IRA is basically a regular retirement savings account, like the ones you might open for yourself. But it’s special because you can fund it for your spouse, especially if they don’t earn much or have no income at all. You can choose either a traditional or Roth IRA for this.
The cool thing is, the contribution limit for a spousal IRA is the same as what you’d have in your own IRA. In 2022, it’s $6,000, and in 2023, it’s $6,500. And if you or your spouse are 50 or older, you can add an extra $1,000 as a catch-up contribution.
So, if either you or your spouse don’t make enough money to save in your individual IRAs, a spousal IRA can be a great way to save for both of your retirements.
Advantages of IRAs
IRAs offer some great perks, such as:
- Investment Choices: You get to pick the type of IRA that suits you best. There’s the traditional one if you want a tax break right away when you put in money. Or you can go for the Roth IRA if you’d rather save on taxes when you retire. Plus, if you’re self-employed or run your own business, there are options that let you save even more.
- Tax Benefits: With traditional IRAs, you can stash away money before taxes, which means you pay less tax now. On the other hand, Roth IRAs give you the advantage of taking out your money in retirement without having to pay any taxes. You get to choose whether you want to save on taxes today or down the road when you retire.
- No Need for an Employer: You don’t have to wait for your boss to set up an IRA for you. You can actually set up the most common types, like traditional and Roth IRAs, all by yourself. This is awesome because it means you can use an IRA to boost your retirement savings even if your job doesn’t offer a 401(k) or something similar. Plus, you can enjoy some tax benefits.
- Easy to Start: If you’re working for yourself or running your own business, IRAs like SEP and Simple IRAs can be way easier to get going compared to other retirement plans like a 401(k). It’s a simple way to start saving for your retirement.
- More Investment Choices: You’ve got lots of options when it comes to where you want to stash your IRA. You can pick from different financial places like brokerage accounts, robo-advisors, banks, and self-directed IRAs. And the cool thing is, these types of accounts usually offer a wide range of investments. That means you can put your money into all sorts of things, way more than you’d find in a regular workplace 401(k) plan.
- Low or No Costs: Starting an IRA is a breeze. Many brokers and banks let you get going without any fees, and you don’t need a big pile of money to begin. It’s a wallet-friendly way to start investing.
- Borrowing Option: You can even borrow from your IRA if you follow the rules. It’s like having a safety net if you ever need some extra cash, but just make sure to stick to the borrowing rules.
FAQ’s
What steps should I take to initiate a Roth IRA or a Traditional IRA?
Starting your Roth IRA or Traditional IRA is straightforward. You can set one up at many places like banks, credit unions, online brokers, or financial service providers. Some well-known brokers that offer IRAs include Fidelity, Charles Schwab, and E*Trade.
To get started, all you need to do is either visit a bank branch or go to their website and fill out a simple form. It’s that easy!
When Can I Take Money Out of an IRA?
The ideal time to start withdrawing from an IRA is when you’re 60 years old or older.
If you decide to withdraw money before you turn 59 and a half, there’s a 10% early withdrawal penalty you’ll have to pay, in addition to regular taxes on the money you take out. However, there are some situations where you might be exempt from this penalty, like for medical expenses, disabilities, buying your first home, or other unusual life events.
In general, the longer you can hold off on taking money out of your IRA, the more time it has to grow and potentially provide you with more financial security later on.
How Does a 401(k) Differ From an IRA?
Both 401(k) plans and IRAs offer tax benefits for people saving money for retirement.
A 401(k) plan is something you can only get through your job. Your contributions come right out of your paycheck, and some employers may even match a portion of what you put in. Plus, 401(k) plans allow you to contribute more money than IRAs.
On the other hand, anyone with earned income can set up an IRA, whether they have a 401(k) at work or not.
When it comes to investment choices, most 401(k) plans have a limited selection of mutual funds and ETFs. But with an IRA, you have a broader range of options, including different funds, individual stocks, and other types of investments to choose from.
