Individual Retirement Accounts (IRAs) have been in the news a lot lately with the recent legislation changes, so it seems like a good time to review the basics of IRAs. All of the technicalities can get confusing fast, and having an understanding of the foundations can help you to avoid getting lost in the weeds.
Although most referred to by its acronym, IRA actually stands for Individual Retirement Arrangement. It’s a type of personal savings account that has special tax advantages. IRAs were first introduced in 1975 as a way for people without access to employer pension plans to save for retirement in a tax efficient way. Legislation surrounding IRAs has changed a bit since then, most recently with the SECURE Act in 2019, but they still serve as one of the most powerful retirement planning vehicles outside of employer retirement plans.
Opening an IRA
You have several choices when it comes to where to open an IRA, including banks, brokers and custodians. Each platform has their pros and cons, so you might consider consulting with a fee-only fiduciary advisor to help you evaluate which platform would be best for you.
Funding
You can contribute to an IRA directly from your bank account, even if you already contribute to an employer sponsored retirement plan. In 2020, the contribution limit for Traditional IRAs is $6,000 (but no more than your earned income), plus an extra $1,000 if you are over 55.
This contribution limit is aggregated across Traditional and Roth IRAs, meaning that your contributions to all IRAs combined (if you have multiple) cannot be more than the limit. Another way to add money to an IRA is to roll money into it from another type of tax deferred retirement account, like a 401(k) or 403(b). These rollovers do not go towards your contribution limit.
Investing
Once you have funded an IRA with contributions or rollovers, you have a choice of how you would like to invest the money that is in your IRA. This is a super important part you don’t want to miss! Contributing money to your IRA is not the same as investing it – you need to be sure to take that next step.
Popular choices for IRA investments include mutual funds, stocks, bonds and CDs. Your choice of investment depends on your goals, account size and risk profile. Your investment choices may also be limited depending on where and how you choose to open your IRA.
Types of IRAs
IRAs can be one of 2 main types: a traditional IRA or a Roth IRA. Contributions to Traditional IRAs are tax-deductible if your taxable income is under a certain threshold. If your taxable income is above this threshold, you can still make contributions to a Traditional IRA, but you are not able to deduct these contributions from your taxes.
- The major advantage of Traditional IRAs over regular taxable investment accounts is that taxes are deferred until you withdraw (until age 59.5). If you make withdrawals before then, you will have to pay an early withdrawal penalty of 10% (although some exceptions exist). Taxes will be paid on the money when withdrawn from the account. Once you turn 73, you will be required to start making withdrawals based on a factor determined by the IRS. See the calculator here: RMD Worksheet. These withdrawals are called required monthly distributions (RMDs).
- Roth IRAs have a different tax advantage to Traditional IRAs in that all distributions from the account are tax free. Contributions, however, are not tax deductible. You will not have to pay tax on any of the growth in the account when you withdraw from it. Another significant advantage of Roth IRAs is that that are not subject to Required Minimum Distributions as are Traditional IRAs.
Note: There are income threshold limits for Roth account contributions, so if you make above a certain threshold you may need to rely on the Backdoor Roth option to fund Roth accounts. Look to employer retirement plans or non-deductible contributions to an IRA to convert to a Roth IRA.
Other Variations of IRA
- Beneficiary IRA is an IRA (either Traditional or Roth) that you inherit from someone else upon their death. These IRAs have Required Minimum Distributions once you inherit them and cannot be combined with other IRAs. You also can’t make any additional contributions to Beneficiary IRAs. If you inherit a beneficiary IRA, evaluate the investments held in the account because, although they were well suited to the original account owner, they may not be a good fit for your unique situation.
- Some employers or business owners might also choose to make use of Simple IRAs or SEP IRAs. These are a different type of IRA than the ones described above and have slightly different rules associated with them.
The longer you invest your money in these accounts, the more tax advantaged savings you will be able to take advantage of. The sooner you start contributing the better. Of course, your decision to contribute to an IRA will impact your other goals, so it is important that you have a financial plan in place before making contributions.
If you would like to know more about IRAs, the internet has a wealth of resources that go into more much detail. Alternatively, you could meet with a professional to help you sift out the information that applies to your unique situation. We can also help you to incorporate IRAs into a strategy that supports your long and short-term goals and values –if you are a Clarity client we will have worked on this planning with you. If you’re not already a client, schedule a call with us find out if we would be a good fit for your needs!
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