An individual retirement account (IRA) is a type of savings account that provides tax benefits. An IRA isn't an actual investment, but rather a type of an account that can be funded with investments, such as stocks, bonds, mutual funds, or CDs. There are different types of IRAs, and each has its own basic features, unique tax implications, and eligibility requirements.
A traditional IRA is a tax-deferred retirement savings vehicle. You won't have to pay any taxes on the earnings of the investments in this account until you withdraw the funds. The distributions are then included in your taxable income. They're taxed as ordinary income according to your tax bracket.
Your contributions can be tax-deductible in the year you make them if you meet certain criteria based on both your income and whether you or your spouse are covered by a retirement plan at work. You must have at least some earned income to contribute.
It used to be that you had to be younger than age 70½ to contribute to a traditional IRA, but the federal government lifted this restriction effective January 2020.
You must begin taking required minimum distributions (RMDs) no later than April 1 in the 12 months following the year in which you reach age 72. An exception to this rule exists if you reached age 70½ prior to January 1, 2020. In this case, you must begin taking RMDs by April of the year after you reached age 70½. You have until December 31 in all subsequent years.
You'll face a tax penalty of 50% of the RMD amount if you fail to meet the required minimum distribution each year.
A Roth IRA is a nondeductible retirement savings vehicle. It provides potentially tax-free growth of retirement savings and distributions, unlike a traditional IRA which grows on a tax-deferred basis. You'll eventually pay taxes on traditional IRA earnings, but not until you withdraw the money. Qualified distributions from a Roth are ordinarily tax-free because you've already paid taxes on your contributions.
The ability to contribute to Roth IRA is based on income limitations, but you make contributions to a Roth IRA even if you're covered by a retirement plan at work.
Like a traditional IRA, a Roth is a type of account that can be funded with stocks, mutual funds, CDs, or other suitable investments.
Roth IRAs aren't subject to RMD rules.
Choosing a Traditional or a Roth IRA
Choosing between a traditional or Roth IRA isn't an either/or decision. You can contribute to both, subject to annual contribution limits. The ultimate deciding factor usually comes down to whether you want to take advantage of the upfront tax break or enjoy tax-free withdrawals later if you feel the need to invest in one or the other.
Consider these deciding factors:
- Estimate how soon you'll need to access your retirement savings. You must generally be at least age 59½ to begin withdrawing funds from either a traditional or Roth IRA without a penalty, and you must own a Roth IRA for at least five years before you can access it without being taxed on the earnings growth. You can withdraw your original contributions without a penalty at any point in time, however. A traditional IRA might be the best choice if you think you'll need the money sooner than five years after you open the account.
- Determine how much of your contributions you can potentially deduct. The choice is easier if you earn too much to make tax-deductible contributions to a traditional IRA due to income restrictions, but you still qualify to contribute to a Roth. You might still be able to use Roth IRA conversion rules to make what's sometimes referred to as a "backdoor" Roth IRA contribution if you earn too much to contribute directly to a Roth IRA—you can make contributions to a traditional IRA, then roll them over into a Roth account.
- Review the estimated taxable income you plan on having in retirement. The tax-free distribution of a Roth IRA might be more appealing if you anticipate being in a high or higher tax bracket in your retirement years.
You can still save with a nondeductible IRA if you can't deduct your traditional IRA contributions or set money aside in a Roth.
Most of the rules that apply to traditional IRAs, such as required minimum distributions and early withdrawal penalties, also apply to nondeductible IRAs.
The distinguishing difference is the tax treatment of your contributions. Like a Roth IRA, you don't get a deduction for your contributions to a nondeductible IRA, but there are significant differences in how the distributions are taxed.
Your nondeductible IRA contributions won't reduce your taxes in the year you make them, but their earnings are tax-deferred, a key tax advantage of a regular IRA. Part of the distribution will be a tax-free return of your original, nondeductible contribution. The remaining amount will be taxed as ordinary income.
Non-deductible IRAs usually make the most sense for those who are already participating in a retirement plan through their employer so they're ineligible to contribute to a deductible traditional IRA. They also make sense for taxpayers whose incomes are above the Roth IRA eligibility threshold.
IRA Contribution Limits
The total amount that can be contributed to a traditional IRA and a Roth IRA annually is limited. The maximum annual contribution for 2020 is $6,000 or 100% of your earned income, whichever is less. This increases to $7,000 if you're age 50 or older.
This limit applies collectively to all traditional and Roth IRAs you own. You can contribute $2,000 to each if you have three accounts and you're younger than age 50, or you can contribute $6,000 to just one of them.
You can contribute to both types of accounts as long as you don't exceed the annual contribution limits.
Traditional IRA Income Limits
Traditional and Roth IRA contributions are also limited by your income: wages, self-employment income, alimony, and non-taxable combat pay. If you have only $4,500 in earned income, that amount is your contribution limit.
This rule is especially important for parents seeking to make IRA contributions on behalf of their children who may have limited income from part-time work.
You won't be able to contribute to a Roth IRA or take a deduction for contributions to a traditional IRA if you earn too much. The limits depend upon whether you or your spouse are covered by an employer's retirement plan.
Married taxpayers whose spouses are covered by a retirement plan at work cannot take a deduction for contributions to a traditional IRA if their modified adjusted gross incomes (MAGIs) are $206,000 or more as of 2020. This drops to $10,000 for those who are married and file separate returns, and to $124,000 if you're personally covered by a retirement plan at work.
Roth IRA Income Limits
As of 2020, MAGI limits for Roth IRAs are:
- $203,000 if you're married and filing jointly
- $10,000 if you're married and filing separately and you lived with your spouse at any time during the tax year
- $139,000 if you're single, qualify for the head of household filing status, or if you're married and filing separately but you did not live with your spouse during the tax year
Early Withdrawal Penalties
Early distributions that are taken before you reach age 59½ are subject to a 10% penalty tax. This tax is in addition to federal and state income taxes at your ordinary income tax rate.
There are some exceptions to the early withdrawal rules, allowing you to take money from your IRA without penalty under certain circumstances, such as to buy a first-time home or to pay for health insurance while you're unemployed.
IRAs for Small Business Owners and the Self-Employed
You might be eligible for other types of IRAs if you work as an independent contractor, have any self-employment income, or run a small business.
Simplified Employee Pension (SEP IRA)
A SEP IRA is a retirement plan that an employer or self-employed individual can establish. The employer receives a tax deduction for contributions made to the SEP plan and makes contributions to each eligible employee's SEP IRA on a discretionary basis.
The key advantage of the SEP IRA is the high annual maximum contribution limit. It's 25% of your compensation or $57,000 as of 2020, whichever is less, and this is much higher than the $6,000 cap imposed on a traditional or Roth IRA.
Savings Incentive Match Plan for Employees (SIMPLE IRA)
A SIMPLE IRA is an employer-sponsored retirement plan offered within small businesses that have 100 or fewer employees. Small businesses often favor SIMPLE IRAs because they're a less expensive and less complicated alternative to 401(k) plans. These plans have specific rules on employer matching incentives, which are built into the plan.
Employees can generally contribute $13,500 to a SIMPLE IRA in 2020. The catch-up contribution limit for 2020 is $3,000, making the SIMPLE IRA contribution limit $16,500 for participants age 50 or older.
Deadlines to Contribute to an IRA
IRA contributions can be made at any time throughout the year, but they must be made by tax day to count toward your contribution limit for the prior year. You can make a 2020 IRA contribution as late as April 15, 2021, for the 2020 tax year.
How to Open an IRA
You can open an IRA through most large financial institutions, banks, mutual fund companies, or brokerage firms. You will typically want to search for an IRA account provider who:
- Has no account fees or very low fees
- Offers a wide selection of no-transaction-fee mutual funds and commission-free exchange-traded funds
- Provides high-quality customer service support and access to unbiased financial education resources, especially if you’re new to investing
- Has low account minimums and fund minimums
How to Fund Your IRA
Every IRA provider has their own unique account setup process. Some IRA providers allow for the ease of online account registration. A few of the key steps involved include establishing a method of funding your account—such as by check, electronic transfers from your bank account, or a rollover—and naming beneficiaries for your account.
How to Invest the Money in an IRA
IRAs allow investment in a variety of different options, including individual stocks, bonds, mutual funds, exchange-traded funds, annuities, and certain types of real estate holdings. The type of investments and the overall asset allocation mix that's right for you depends on your risk tolerance and time horizon.
You can choose an “all-in-one” investment fund, known as a target date retirement fund, that takes care of your asset allocation for you, or you can customize your portfolio if you're a hands-on investor.
Is an IRA the Right Choice for Retirement Savings?
An IRA might be the simplest, most efficient way to save for retirement, but it can depend on your goals. Your employer might offer a 401(k) option, and these plans come with higher contribution limits if you're in a hurry to save—up to $19,500 in 2020. A savvy investor might prefer developing their own portfolio of various investments, while a simple savings account isn't likely to get you very far.
Consider speaking with a financial advisor to narrow down your choices and determine what's best for you based on your age and income.
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