IRA stands for an individual retirement account and this is a savings account in which people put some money for “rainy days” – retirement. These accounts offer some tax advantages and there are two main types – Traditional and Roth IRA.
To have an IRA you must meet two major requirements – you should be under the age of 70.5 and also have a monthly income.
Your IRA will invest the money you have put into the account in various business opportunities – stocks, bonds, and make a profit for you.
Can We Consider IRA As An Investment?
IRAs are not only a savings account – you can invest the money in various endeavors. According to most experts, they offer a wider range of investment opportunities compared to 401(k). For example, you can buy individual stocks, but this is very time-consuming. You can also invest in bonds or you can trade.
If you are not one of those people who feel really confident about financial markets and investing, or you don't have enough time, put your money in mutual funds. They will take care of everything.
Different Types of IRA
First, let's take a look at Traditional IRAs and their specifics:
Traditional IRA Contribution Limit
There is a limit when it comes to your annual contributions – no more than $6,000 a year if you are 49 or below. If you are age 50+, the maximum contribution is $7,000, as of 2019. Keep in mind that these limits do not change every year; they are adjusted to inflation movement.
This is far less than the amount you can contribute to a 401(k) – $18,000 if you are 40 or younger. Keep in mind that this $6,000 is a tax-free amount of money. In addition, the rule applies to all your IRAs, if you have more than once. So, the more IRAs you have, the more tax-free money you can invest.
If the IRA holder reaches 50 or is older, they are permitted additional $1,000 annual contributions. Be careful, though. If you exceed your annual limits, the company will impose a 6% penalty on the amount of money above $6,000. So, if you have invested $7,500 in your IRA account, then you have to pay a 6% penalty on $1,500.
Now that you know about the $6,000 limit, let's mention the specific conditions under which this amount of money is tax-free. According to the Internal Revenue Service (IRS), there are two factors which determine whether this amount can be deducted from your taxable income or not – adjusted gross income (AGI) and participation in an employer-sponsored retirement account. Here we have several scenarios:
- For people who are not married and their company provides them with a retirement account, if you want to make tax-free contributions to your IRA, your AGI should be $62,000 or less.
- If you are married and the company you work for does not offer a retirement plan to you, then you can deduct the $6,000 from your taxable income. However, if your spouse's company offers a retirement plan to him/her, then to take advantage of the tax deduction your family adjusted gross income should not exceed $193,000. You should also file your taxes together.
- If you are married and both of you are covered up by your employer, you can deduct the annual contributions from your taxes only if your AGI does not exceed $103,000.
Having a retirement plan provided by your company does not necessarily mean that you can't have your personal IRA. Simply, the annual contributions might not be tax-free. You'd better advise your tax consultant to see if the contributions to your personal IRA will be tax-deductible.
This is a type of retirement plan offered by employers and the abbreviation stands for a Savings Incentive Match Plan for Employees.
Usually, small businesses offer this option and the reasons they prefer it over 401(k), for example, is that it's cheaper. The employer may contribute 2% flat of the employee's salary whether they wish or not. In addition, the employee himself can contribute to the plan up to 3% of their salary.
This year the contribution limit is $12,500 per year. Sometimes employers allow their employees to make additional catch-up contributions up to $3,000. This makes $15,500a year.
A Simplified Employee Pension (SEP) IRA is a type of Traditional IRA and is a retirement plan perfect for small businesses and self-employed professionals. Businesses owners can make tax-free contributions for all their employees as well as themselves. The maximum an employer can contribute to an employee account is 25% of their annual salary. Self-employed can contribute as much as 20% of their net earnings.
Currently, the maximum contributions a person can make annually to a SEP IRA is $54,000 which remains unchanged from last year. Unlike SIMPLE IRAs, these accounts do not offer catch-up contributions, but I wouldn't be so disappointed given the substantially higher limits.
Withdrawals From Traditional IRA
Under normal conditions, an individual cannot make withdrawals from a traditional IRA before the age of 59.5. If you make a withdrawal, say when you are 49, then a 10% early distribution penalty will be imposed. Also, you may have to pay state taxes on these amounts of money. However, there are some exceptions to the rule. You can make penalty-free withdrawals before the age of 59.5 under some conditions:
- In case of death of the owner
- In case of unreimbursed medical expenses
- Permanent disability of the owner
- Qualified educational expenses
- To cover health insurance premiums if the owner is unemployed.
You should also know that after the age of 70.5, you have to start making regular distributions from your IRA – Required Minimum Distributions (RMD). If you don't do that, you will have to pay a penalty.
Required Minimum Distributions (RMD)
If you are an owner of a Traditional IRA, you have to start making regular distributions when your reach age 70.5. You can either withdraw the whole amount in the account or make regular distributions. The company that holds your account usually calculates your RMD, but if you want to have an idea, try this one:
- Check out the balance of your IRA on 31 December last year
- Find the distribution factor corresponding to your age (the older the person, the lower the factor)
- Divide the balance by the distribution factor
Differences Between Traditional and Roth IRA
If we look at both types separately and in more detail, we will see that there are many differences. Each one of them has its specifics and characteristics. However, they are both tax-advantaged savings accounts but this is also where their differences lie.
If you remember, previously in the article, contributions to a Traditional IRA are free of taxes if you meet certain criteria. Roth IRA does not offer tax-deductible contributions.
If you withdraw contributions or earnings from a Traditional IRA, you have to pay taxes. If you do the same from a Roth IRA, you will not pay taxes if it's a qualified distribution. Basically, the rule is: Roth IRA offers tax-free growth and Traditional IRA provides tax-deferred growth.
3. Minimum Required Distributions (MRD)
The IRS requires you to start making MRD from your Traditional IRA once your turn 70.5. There is no such requirement for a Roth IRA as long as you are the original account holder.
4. When You Can Make Withdrawals
Regarding Traditional IRAs basically you can do it anytime, you will have to pay an early distributions penalty which is 10%. If you want to make penalty-free distributions, then the required age is 59.5. As you already know, there are a few exceptions to the rule.
You can make a tax- and penalty-free distributions from a Roth IRA even if you are under age 59.5. However, you might have to pay taxes on the earnings your savings account has generated.
Traditional or Roth IRA – Which One Is For You?
It's hard to say which one is better. Certainly, you have to make sure what your future goals are and what you would like to achieve. Given the specifics of the two types of IRA, we can assume:
If you think that after retirement the tax rate will be lower, then go for a Traditional IRA which offers a tax-deferred growthIf you want to pay taxes now because you think they might be higher after retirement, then take advantage of a Roth IRA and its tax-free growth option.
What most experts advise is that Roth IRA is more suitable for younger people and the Traditional IRA for older folks. Why? Well, it's safe to say that when you start early your career, the rate of taxes you have to pay will increase in time. Therefore, pay taxes when they are low.
An IRA is a great way to save a decent amount of money for the days when you retire. After retirement usually people's income drops significantly and it can be very discouraging. You can make sure that does not happen and start making contributions when you are even 30. The younger you are, the more money you can save. Opening an IRA account does not only give you the chance to make tax-free contributions for the golden days but also to invest your money in a wide variety of investment opportunities.