Individual Retirement Accounts, or IRAs, provide an additional option for saving for retirement. These accounts can be used to mitigate your tax burden, and they’re also very popular to use in the pursuit of FI/RE. Read on to learn about everything you need to know about IRAs.
What is an IRA?
One of the two main types of retirement accounts is an Individual Retirement Account, or an IRA. The main difference is that one is employer-sponsored plan (ex: 401K, 403b, 457, TSP) and the other is not (IRA). The IRA is meant for individual investors, hence its name. Read on to learn about everything you need to know about IRAs.
An IRA is what you would consider tax-advantaged. For something to be considered tax advantaged, it must be tax-exempt, tax-deferred, or offer some other form of tax incentive. The kind of tax incentive you will receive depends on the type of IRA you choose. Regardless of the type of IRA you choose, they all share some basic similarities:
1. Investments range in type
Within your IRA, you can choose from stocks, bonds, ETFs, and mutual funds, including index funds. What you choose depends on your preferred asset allocation.
2. You can only contribute to your IRA with earned income
When thinking of earned income, think of taxes. If you paid taxes on it, or will have to come tax season, it is earned income. A few sources that are not counted as earned are: interest and dividends, social security, or unemployment. Refer to IRS guidelines for more information.
3. There are contribution limits
The two most common types of IRAs—traditional and Roth—have a current 2020 IRA contribution limit of $6,000/year ($7,000 if you’re 50 or older). This number can even be less depending on your modified adjusted gross income (MAGI). Read below to see a comparison of some of the most common full contribution limits.
|Filing Status||2020 MAGI||Contributions|
|Single or Head of Household||Less than $124,000||Up to the limit|
|Married filing jointly||Less than $196,000||Up to the limit|
|Married filing separately||$206,000 or more||Zero|
4. There is an early withdrawal penalty fee of 10% if you take earnings out before age 59 1/2. Certain situations will allow you to withdraw some portion of your contributions penalty-free.
Because this is a retirement account, you will incur a 10% early withdrawal penalty—not including taxes—on your withdrawals. Certain exceptions, however, allow you to withdraw a portion of your contributions:
- Qualified higher education expenses
- Qualified first-time home buyers, up to $10,000
- Medical expenses
The four types of IRAs
The umbrella term is an IRA. Within this, you have four types:
- Traditional (Pre-Tax)
- Contribute pre-tax money, pay taxes upon withdrawal. This lowers your current tax liability.
- Roth (Post-Tax)
- Contribute post-tax money, no additional taxation upon withdrawal. Provides tax diversification and lowers your future tax liability.
- SEP IRA
- For self-employed people
- SIMPLE IRA
- For small business owners
The last two (SEP IRA and Simple IRA) are great for business owners or operators. The SEP IRA, or Simplified Employee Pension IRA, lets self-employed people (including contractors) and small business owners save towards retirement. The contributions are higher for this type of IRA, although there are also limits and requirements.
The Simple IRA, on the other hand, is intended for business that are a bit larger than those opting for a SEP IRA. With the Simple IRA, or “Savings Incentive Match Plan for Employees,” employers can provide a match to their employees’ contributions. While it may share similarities to the 401K, the Simple IRA is intended for small businesses with 100 employers, or less.
Difference between Traditional IRA and a Roth IRA
These are the two most common IRAs. While very similar, there are some key differences between what the two IRAs are.
|IRA Type||Employee Contribution |
|Traditional IRA||$6,000/year, or $7,000 if 50 or older||Yes||No|
|Roth IRA||$6,000/year, or $7,000 if 50 or older||No||Yes|
The main difference is the tax benefit and at which point it occurs. If your current income tax bracket is high right now, then it might be convenient to open a Traditional IRA and save on taxes today. If your income tax bracket is lower right now, saving in a Roth IRA may be a better choice, if you anticipate being in a higher tax bracket in retirement.
Through the Roth IRA, you can:
- Contribute money that will grow tax-free
- Reduce your future tax burden, since you don’t pay taxes on Roth contributions or earnings upon withdrawal, after meeting eligibility requirements.
The Roth is great especially for young people who are typically in lower income and tax brackets. Opening a Roth IRA at this stage means that your money will go into your account after taxes (at your current rate) and will grow tax-free until you choose to withdraw the funds during retirement.
How to open an IRA
Personal finance blogger Funancialism says it takes 4 minutes 33 seconds to make your Roth IRA. The most important decision that will help you decide where to turn to is dependent on the kind of investor you want to be:
- Are you hands on?
- Are you hands off?
For a hands on investor, you will want to look for brokerages who have low or no fees, offer an extensive assortment of financial products, and provide reliable customer support through a solid user interface, educational materials, and accessible dial-in assistance.
For the hands off investor, you will want to look for robo-advisors, who manage your account after pre-selected settings at a low management fee (typically 0.40% or less). A robo-advisor will often automatically rebalance your portfolio and adjust allocations correspondingly. The only thing you will have to do is continue contributing money.
My favorite place to start my brokerage research is through updated monthly “summary of best X” lists from popular financial blogs. For the month of September 2020, Nerd Wallet has published this list, which holds a variety of brokerage options that offer IRA.
Building Wealth through an IRA
The moment you realize that wealth is not built by saving but rather by investing, you start your path towards building generational wealth. While a 401K is probably something you’ve heard about at some point in your life, the 401K is not the most accessible form of investing because it is contingent on your employer. For this reason, the IRA is considered to be one of the most accessible forms of investing. The US financial and tax systems values investors and asset builders. Creating and funding your retirement account begins to give you access into some of the benefits offered to these wealth-building tools.