Understanding Individual Retirement Accounts—IRAs
Individual retirement accounts (IRAs) are basically savings plans with a number of restrictions. The main advantage of an IRA is that you can defer paying taxes on the earnings and growth of your savings until you actually withdraw the money. The main disadvantage is that tax law imposes penalties if you have to withdraw any of the funds before you reach age 59 1/2.
There are several different types of IRAs. Each has its own tax implications and eligibility requirements.
You can claim a tax deduction when you contribute money to a traditional IRA. Since this deduction reduces your taxable income, you don't pay income tax on the money you set aside in the account. The savings grow tax-deferred. You won't have to include interest, dividends, or capital gains from the IRA on your annual tax return.
When you withdraw the money, the distribution from the IRA is included in your taxable income. It's taxed as ordinary income—effectively paying taxes later on the money you earn today. Many retirees find themselves in lower tax brackets than they were subject to when they were working and earning, so you might end up paying less of a tax rate on distributions from an IRA.
If you need to withdraw from your IRA prior to retirement, you'll pay income tax as well as an additional 10% tax penalty on early distributions if you withdraw the money before you reach age 59 1/2.
You must begin withdrawing money from a traditional IRA April 1 of the year after you turn 72. You must take at least the required minimum distribution (RMD) each year. Otherwise, you'll be taxed 50% of the RMD amount that was not distributed.
Depending on your situation, you may be able to claim deductions from your contributions.
There are some restrictions on who can take a deduction for traditional IRA contributions. If you or your spouse are also covered by a retirement plan at work, your deduction may be limited, or you might not be able to deduct any of your contribution at all.
Nondeductible Traditional IRAs
A nondeductible IRA is a traditional IRA, but the contributions aren't tax-deductible because they are made with after-tax dollars. The advantage to this option is the savings will still grow tax-deferred until you begin to take distributions. The principal portion of those distributions is tax-free in retirement because you already paid taxes on the invested money when you earned it—it is the growth portion that is taxed as ordinary income.
People usually opt for a nondeductible IRA when they find themselves in a very specific financial situation, including all of the following:
- They're covered by a retirement plan through their employer.
- Their incomes are too high to be eligible to deduct their traditional IRA contributions.
- They aren't eligible to fund a Roth IRA.
- They want to contribute extra savings towards retirement in a tax-deferred account.
The primary difference between a nondeductible IRA and a traditional IRA is the tax treatment of the original contribution. All other rules that apply to traditional IRAs also apply. There's still a 10% surtax penalty on early distributions, and distributions must begin in April, the year after the account holder reaches age 72 (or at 70 1/2, if you turned 70 1/2 before Jan. 1, 2020).
A Roth IRA provides potentially tax-free savings and distributions. Unlike a traditional IRA, you don't get a deduction for your contributions when you make them. This makes these accounts similar to nondeductible IRAs, but there are significant differences in how the distributions are taxed.
- Contributions are not tax-deductible.
- No income tax on the earnings and growth of the savings inside a Roth IRA.
- Distributions from a Roth IRA are tax-free if you meet certain conditions.
- You can have a Roth IRA even if you're covered by a retirement plan at work.
Simplified Employee Pension IRAs
SEP-IRAs are a type of group retirement plan. An employer establishes the SEP-IRA plan, then makes contributions to a traditional IRA that's set up inside the SEP-IRA. These plans are popular with self-employed people because they allow for higher contribution limits than regular IRAs.
Otherwise, SEP IRAs are treated similarly to traditional IRAs. Contributions are made with pre-tax dollars, distributions are taxed as ordinary income, and there are penalties for taking early distributions.
Savings Incentive Match Plans for Employees
SIMPLE IRAs are also a form of group retirement plan. They're easier to set up and maintain than 401(k) or pension plans, but they offer lower contribution limits than other group plans. SIMPLE IRAs allow you to contribute pre-tax dollars with matching contributions from your employer. Distributions are taxed as ordinary income, and there are penalties for early distributions.
IRA Contribution Limits and Deadlines
The total amount you can contribute to a traditional IRA or a Roth IRA each year, or any combination of the two, is limited to $6,000 for the years 2020 and 2021. You are able to contribute more if you're age 50 or older—up to an additional $1,000.
These contribution limits apply across traditional, nondeductible, and Roth IRA types. If you want to fund both a traditional IRA and a Roth IRA, you can contribute any combination of funds to each, but the combined total can't exceed the annual limit. For example, you might put $3,000 into a traditional IRA and another $3,000 into a Roth IRA (for 2020 and 2021).
Contributions for a SEP-IRA in 2020 are limited to 25% of an employee's compensation, or $57,000, whichever is lowest. The limit for 2021 is $58,000.
You can contribute funds to an IRA at any time throughout the year. After the year has ended, you can still make a contribution towards the previous year's IRA as long as the contribution is made by the April tax deadline.
For the years previous to and including 2019, the ability to make contributions stopped at age 70 1/2 for a traditional IRA. After Jan. 1, 2020 you are able to continue contributing to both traditional and Roth IRAs regardless of your age.
Is an IRA Right For You?
While it is considered a worthwhile investment to have an IRA, it is not an option for everyone. The circumstances in people's lives dictate the type of IRA they might choose, as well as if they can afford to contribute to an IRA.
If you do not have enough income to fund contributions into an IRA, you may need to wait until you do have enough extra money to do so. If you are young and just beginning your career, a retirement fund might be the last thought on your mind. Some do not start investing in an IRA until later in life.
Regardless of circumstances or age, an IRA is a way for you to save for retirement, while the money being saved works for you to generate more savings. If you have the means to do so, an IRA is a good start for your retirement.
When considering an IRA, always bear in mind the tax burden you are able to carry at the present moment, and when you plan to take distributions. The different IRAs can help you pay your taxes on distributions when you can most afford it.