Perhaps you’ve heard about individual retirement accounts (IRAs) but know little about what they are or how they can help you reach your retirement goals. To get you started, let’s take a look at four basic facts about IRAs.
An IRA is a long-term savings plan that is designed to help working people save for retirement. Its tax benefits are similar to those of an employer-sponsored retirement plan such as a 401(k) or 403(b.
If you’re self-employed or a freelancer, or if your employer doesn’t offer a 401(k), the IRA is your best option for saving toward retirement while reducing your taxable income. If you have access to both a 401(k) and an IRA, it’s a good idea to save in both types of plans to diversify your investments.
You can choose from a huge variety of IRAs from almost any bank or brokerage. Unlike in a company-sponsored 401(k), you can invest in almost anything you want.
Key Takeaways
- There are annual limits as to how much you can contribute to an IRA, whether it’s a traditional or Roth IRA.
- Your income determines whether you are eligible to contribute to an IRA and how much you can contribute.
- With a traditional IRA, your contributions are made with pretax funds and reduce your taxable income for the year. You’ll owe the taxes due only when you withdraw money.
- With a Roth IRA, your contributions are made with post-tax funds. Your withdrawals are not taxed.
- You can withdraw your contributions from a Roth IRA tax-free and penalty-free at any age.
1. IRA Limits
For 2022, the Internal Revenue Service allows you to contribute as much as $6,000 if you’re younger than age 50 and $7,000 per year if you’re 50 or older. For 2023, the IRS allows you to contribute up to $6,500 (or $7,500 if you’re age 50 or older).
You must have earned income to contribute to an IRA. That can include a spouse’s income if you’re married and file jointly.
2. Types of IRAs
There are two primary different types of IRAs: traditional and Roth. The traditional IRA doesn’t require that you pay taxes on your gains until you start taking required minimum distributions (RMDs).
As of Jan. 1, 2023, the age at which you must begin taking RMDs was raised to 73 from 72.
Because the money has not been taxed (yet), the traditional IRA keeps more money in your account over time, and that allows the money to compound at a faster rate.
The Roth IRA requires that you pay taxes now, at your current tax rate. This allows your earnings to grow tax-free. If you anticipate being in a higher tax bracket in the future, the Roth is probably your best choice.
Aside from those two popular choices, there are many other types of IRAs including:
- SEP IRAs, which allow employers (usually small businesses or self-employed individuals) to make retirement contributions.
- SIMPLE IRAs, which are designed to be offered by small businesses.
- Self-directed IRAs, which are very similar to traditional or Roth IRAs except there are limits to the investment options.
If you earn above a certain amount, you cannot contribute to a Roth IRA. The limits are revised yearly.
3. IRA Eligibility
With the traditional IRA, the deductions for your contribution amounts are limited if you’re also covered by an employer-sponsored plan.
Full Deduction Allowed
For 2022, individual taxpayers earning $68,000 or less can take a full deduction. Married couples earning less than $109,000 can make the full deduction.
These limits have been increased for 2023. Individual taxpayers earning $73,000 or less or married filing joint taxpayers earning less than $116,000 can make the full deduction.
Partial Deduction Allowed
A partial deduction is available for single filers earning more than $68,000 but less than $78,000 in 2022. Married couples making between $109,000 and $129,000 can get a partial deduction for 2022.
These limits have also been increased for 2023. Individual taxpayers earning between $73,000 and $83,000 may still take a partial deduction. In addition, married filing joint taxpayers earning between $116,000 and $136,000 can take partial deduction as well.
No Deduction Allowed
There is a cap on the allowable modified adjusted gross income (MAGI) of a taxpayer in order to take this deduction. If an individual’s MAGI exceeds $78,000 in 2022 or $83,000 in 2023, they are not eligible to take the deduction. The same is true for married filing joint taxpayers earning more than $214,000 in 2022 or $228,000 in 2023.
If your traditional IRA isn’t tax-deductible, a Roth IRA is the better choice. With the Roth IRA, contributions are made with after-tax dollars and there are income limits.
4. IRA Costs
In order to open an IRA, you’ll need to visit a bank or an investment broker, in person or online.
Some online brokers offer no-fee IRAs other than the commissions for buying and selling within the account. Other brokers will charge a yearly management fee, even if they aren’t managing the account for you.
Look for a no-fee IRA. A 1% management fee can significantly cut into your balance over a 20-year period, so it’s important to keep fees to a minimum.
What Is the Difference Between a Traditional IRA and Roth IRA?
A traditional IRA is funded by pre-tax dollars, meaning you get an upfront deduction. You will owe income taxes in the year in which you make a withdrawal.
A Roth IRA is funded with after-tax dollars. Although you get no immediate tax benefit, your contribution and all of its earnings can be withdrawn in the future tax-free.
The Roth IRA also boasts more flexibility for withdrawals than a traditional IRA. You’ve already paid your income taxes due on the money, so it’s yours if you want it early.
Is a Traditional IRA Better Than a Roth IRA?
One IRA isn’t necessarily better than the other. One may be better suited for some investors.
Traditional IRAs tend to favor people with higher incomes in the short term because the contributions reduce their immediate tax liability. Roth contributions tend to favor younger, lower-income savers who may expect to be in a higher tax bracket in the future.
What Is the Difference Between an IRA and a 401(k)?
Both are investment accounts that house long-term savings for retirement.
A 401(k) is an employer-managed plan. The employer will choose the investments available to you, select the broker on your behalf, and oversee the plan administration. The employer may contribute a co-payment to your account, which is a substantial employee benefit.
An IRA is a self-managed retirement account that you choose and oversee. You have much greater flexibility and choice.
The Bottom Line
Whether it’s a Roth or traditional IRA, get started. The money that is sitting in your savings account, earning little to no interest could work harder for you in an IRA even with safe investment choices.
Don’t know how to invest the money? Ask a fee-only advisor for some help. Many are happy to charge you a one-time fee and a fee for an annual consultation.
Source: https://www.investopedia.com/financial-edge/0212/4-basic-facts-to-know-about-iras.aspx?utm_campaign=quote-yahoo&utm_source=yahoo&utm_medium=referral&yptr=yahoo