An IRA, or Individual Retirement Account, is a common investment tool that allows individuals to earn and earmark funds for retirement savings. It is an investment account capable of housing stocks, bonds, mutual funds, and various other assets within the account itself. IRAs offer generous tax incentives, but are geared for retirement age since penalties can be incurred for withdrawing money too early. Unlike a 401(k), an account provided by your employer, an IRA must be opened on your own behalf.
Retirement Savings | Knowing The Basics
You may have heard of both a ‘Traditional IRA’ and a ‘Roth IRA’. While there are noteworthy discrepancies between the two, we will look at the primary distinction concerns when you pay taxes on your contributions to the account. We’ll get there in a moment.
What do you mean by ‘generous tax incentives’?
IRAs are unique in that they are free from some of the tax burdens levied on other such investments. An IRA’s growth that comes from interest, dividends, and capital gains is untaxed. Imagine you could invest $65k over the course of your life and then pull out $130k without owing taxes on that growth. It makes the most of your returns.
So there are no taxes on an IRA?
Not quite. On a Traditional IRA, you pay taxes on the money you contribute to the account when you withdraw your money at retirement. Alternatively, a Roth IRA collects income taxes on the front end, but none are paid when you retire – as you’ve already paid the taxes when you made your contributions. For both, though, the growth of your investment remains tax-free once it’s in the account.
Upon retirement, withdrawals from a traditional IRA are taxed as regular income and therefore based upon your tax bracket that year. In a Roth IRA, your withdrawals are tax-free as long as you are 59 1/2 or older.
How much should I be contributing?
While everyone has a different plan for their financial retirement goals, you should always try to contribute as much as the government allows you to. The more you save in a tax-free account, the more tax-free growth you can enjoy.
As of 2016, most Traditional IRA investors younger than 50 are limited to $5,500. For investors older than 50, you may contribute $6,500 annually – enticing more savings in the final years before retirement. A Roth IRA is a bit different as it depends on your income and spousal/filing status.
When do I start taking the money out?
In a traditional IRA, you must begin taking minimum distributions from your account when you turn 70 1/2. The amount depends on upon how much you’ve saved and your estimated life expectancy, based upon tables established by the IRS.
In a Roth IRA, you can leave the money in the account indefinitely.
But what if I need access to the money before I retire?
If you withdraw money from either a Roth or traditional IRA before you turn 59 1/2, you will pay a penalty. That said, there are a few exceptions. Helping with a family member’s college expenses, buying a first home, certain medical expenses, and sudden disability make up most of the list.
There are few other safeguards in place, should you desperately need money, but aim to avoid withdrawing funds early.
Does my money do anything in an IRA?
Yes! That’s the best part. You can use funds from your IRA to invest in just about anything. You can invest in things like mutual funds, stocks and bonds, certificates of deposit, annuities, and in certain circumstances, real estate; the returns on which remain tax-free while in the account. Essentially, you can grow the value of your IRA without paying income taxes on it.
How do I open an IRA?
Almost any large bank, mutual fund company, brokerage firm, and general financial institution offers IRAs. There is often a large breadth of options for investment, ultimately building a rather diversified portfolio within your IRA. All institutions will have varying fee structures, so do your homework before choosing where to go.
How do I know if it’s the right choice for me?
Opening an IRA is about planning for the day you stop working. It is tough to conceive of what your financial circumstances will be then, but the appeal of an IRA is that much less of your money will go to the tax collectors when you retire and begin withdrawing from your long-term investment.
If you believe your current tax rate will be higher than what you’ll face in retirement, a traditional IRA may be a good idea – ensuring you get a tax break when it benefits you most. Remember, the money you put in a traditional IRA may be deductible from your taxes for the year. If you think you are in a lower bracket now than you will be later, however, you may want to consider a Roth IRA. You have already paid taxes up front, so you’ll get the big tax break in the future.
You can maximize your savings too, even if you already have a 401(k). If you have access to a 401(k) through your employer and they match some of your contributions, your first priority should be to save there. However, opening an IRA would allow for even further growth of your capital inside tax-advantaged accounts.
What do you think about investing for retirement savings? Let us know in the comments section below.