In terms of retirement savings, you’re probably on your way with an employer-sponsored 401(k) account. However, that’s not the only retirement account option.
One of the most preferred retirement options is an individual retirement account (IRA). Available in several types and offering appealing benefits, IRAs can give you a leg up in funding for a healthy retirement.
In this article, you’ll learn the basics of an IRA, how it works, various types, benefits, and how to open one. Let’s start.
Table of Contents
Understanding IRA
An IRA is a tax-deferred investment account that allows you to save for retirement. This means you can allow your savings to grow tax-free. Depending on the type of IRA you choose, you may have tax-deductible contributions or tax-free withdrawals.
The special tax treatment offers extra compound growth on your savings beyond what you’d typically see in a taxable investment account.
How Does IRA Work?
Anyone who earns income and those who don’t can open and contribute money to an IRA account. However, it has limitations on the combined total you can contribute to your accounts in a single year to get the tax advantages.
When opening any type of IRA, you can invest in a broad range of financial products, including bonds, stocks, mutual funds, and exchange-traded funds (ETFs). Some accounts, like self-directed IRAs, also allow investors to make all investment decisions.
Others provide more access to a wider selection of investments, including real estate and commodities like gold. So, how does gold IRA rollover work? A gold IRA rollover allows you to move savings from other retirement plans to a gold IRA account. That said, riskier investments are often off-limits.
Since IRAs are designed for retirement funding, early withdrawals (before age 59 ½) can incur a penalty of up to 10%. Other types may cause you to owe income tax on early withdrawals. That said, there may be some exceptions, for instance, withdrawals for first-time home purchases or educational expenses.
5 Common Types Of IRA
As mentioned before, there are several types of IRAs, each with different taxation rules, eligibility, and withdrawals.
1. Traditional IRA
With a traditional IRA, contributions are tax-deductible. As a result, you won’t have to pay taxes on the earnings from your IRA account until you reach retirement. Your retirement withdrawals will then be subject to income tax. Most retirees are in a lower tax bracket before retirement, so the money from their traditional IRA can be taxed at a lower rate.
In 2022, the contribution limit is USD$6,000 annually. Meanwhile, people 50 and older can contribute USD$7,000 every year.
If you’re married and either or both of you have a retirement plan at work, the amount of contribution you can deduct is reduced and may be eliminated altogether if you hit a certain income.
That said, you can still make contributions, but they won’t be tax-deductible. However, if you and your spouse don’t have any retirement plans at work, you can deduct your IRA contributions regardless of your total income.
2. Roth IRA
A Roth IRA is an individual retirement account that offers tax-free growth and tax-free withdrawals in retirement. Contributions to a Roth IRA are made after taxes have been paid, which means that the money you contribute has already been taxed. This makes Roth IRAs different from traditional IRAs, where contributions are made with pre-tax dollars and are taxed when you withdraw them in retirement.
Roth IRAs are a great way to save for retirement because they offer the opportunity for tax-free growth on your investments. This means that you can grow your money without having to pay taxes on the gains. And, when you withdraw the money in retirement, you won’t have to pay any taxes on it either.
There are some limitations on how much you can contribute to a Roth IRA each year, depending on your income and tax filing status. But, if you qualify, you can contribute up to $6,000 per year (or $7,000 if you’re 50 or older).
3. Rollover IRA
Rollover IRAs are standard IRAs holding funds you’ve ‘rolled over’ from an employer-sponsored retirement plan such as 401(k). For instance, if you’re changing jobs from being an employee to a self-employed status or approaching retirement, you can move your retirement savings from your old 401(k) to an IRA account.
A rollover IRA is also a good idea if your old employer’s 401(k) offering has limited investment options or it’s unavailable to employees who have already moved on. You might want to move your funds into a Roth IRA to benefit from tax-free withdrawals during retirement.
That said, if your account is not yet on a Roth account, you may owe taxes on the amount you wish to convert.
4. SEP IRA
SEP IRAs are designed for self-employed individuals, such as freelancers, independent contractors, or small business owners. Businesses can adopt a SEP IRA plan, but only the employer makes contributions.
It’s closely similar to traditional IRAs–you have tax-deductible contributions, money grows tax-deferred until retirement, and withdrawals are taxed as income. This type of IRA offers a higher contribution limit than regular IRAs.
For instance, employers may contribute up to 25% of an employee’s income or USD$61,000 in 2022, whichever is less. Meanwhile, small business owners and self-employed individuals contributing to their own SEP IRAs may have slightly fewer contributions.
5. Savings Incentive Match Plan for Employees (SIMPLE) IRA
A SIMPLE IRA is a retirement investment account for small businesses with 100 or fewer employees. Unlike SEP IRAs, both employees and employers can contribute to SIMPLE IRAs.
Employers are required to make contributions, while employees can choose whether or not they want to contribute. In 2022, employee contributions are capped at USD$14,000. Meanwhile, employers can choose to make a dollar-for-dollar matching contribution of up to 3% of the employee’s salary or make contributions equal to 2% of the employee’s salary.
Benefits Of IRAs
IRAs offer several advantages over other retirement savings accounts. Its main benefit is that your money can grow and compound, whether tax-deferred or tax-free. However, that’s not the only perk. Some of the advantages of choosing an IRA include the following:
- You have different options for investment accounts that a workplace retirement plan doesn’t provide
- You don’t need an employer to open an IRA account
- You have more flexibility in terms of investment options
- You can borrow from an IRA account
- Most financial institutions have no fees and no minimum balances in opening an IRA
- Opening an IRA account is fast and simple
How To Open An IRA?
In general, opening an IRA account is fairly simple. Online brokers are the best option if you want to choose investments for yourself.
However, suppose you’d rather let others manage your investments. In that case, you should consider working with a financial advisor or a robo-advisor, which is a service that chooses risk-appropriate and low-cost investments for you.
In addition, major banks may also offer IRA accounts, although they usually offer deposit products, such as certificates of deposits (CDs).
Final Thought
An IRA offers a unique and great way to save for your golden years. Anyone with earned income can easily open one, even those without access to employer-sponsored retirement plans.
That said, before you dip your toes into the wide world of IRAs, ensure you’re fully equipped with the knowledge and have a better sense of which type is the best for your situation.
Hope this article should have provided you with the basics of IRAs, but make sure to further your research to learn and understand more about IRAs before opening one.
