What is an IRA?
An individual retirement account (IRA) is an account used to save for retirement. The IRA is specifically designed for self-employed individuals who do not have access to workplace retirement accounts such as a 401(k). However, anyone with an earned income can open and contribute to an IRA, including those who already have a 401(k) account through an employer. There are limitations on the total amount you can contribute to your retirement accounts in a single year. You can open an IRA through a bank, investment company, an online brokerage, or a personal broker. You typically cannot withdraw money from these accounts before reaching the age 59 ½ without incurring a large tax penalty of 10% of the amount withdrawn. There are some notable exceptions to this – educational expenses and first-time home purchases, among others. There are annual income limitations in place as well that apply to deduction contributions to traditional IRAs and contributing to Roth IRAs. There are 4 types of IRA, each with different rules regarding eligibility, taxation, and withdrawals:
Traditional IRAs: With a traditional IRA, you can put pre-tax dollars into your retirement investment account to let it grow tax-deferred until you begin making retirement withdrawals at age 59 ½ or later. Custodians, including commercial banks or brokers, will invest the funds you deposit into different investment vehicles based on both your instructions and the offerings available. You can deduct your contributions from your income tax return, meaning the IRS will not apply income tax to the earnings deposited into your IRA. When that money is withdrawn down the road, your earnings will be taxed at your income tax rate at the time of retirement. If you expect to be at a lower tax bracket when you retire than what you’re at now, a traditional IRA may be recommended. If you have another retirement savings fund in place, such as a 401(k), the IRS may limit the amount of your traditional IRA contributions that can be deducted from your taxes.
There are required minimum distributions (RMDs) from traditional IRAs depending on your age and when you were born. You must begin taking distributions by April 1 of the year after you turn 70 ½, 72, or 73 depending on when your birthday falls. If you choose to withdraw funds prior to your full retirement eligibility, you will incur a 10% penalty of the amount withdrawn and taxes at standard income tax rates. However, there are several exceptions to these penalties.
Some of these exceptions include:
The purchase or rebuilding of a first home for yourself or a qualified family member
You become disabled
To cover expenses to afford higher education
Expenses incurred for having or adopting a child
Paying for medical insurance after losing your job
You are in the military and called to active duty for more than 179 days
You use the assets for unreimbursed medical expenses
Roth IRAs: A Roth IRA is a much more flexible option than traditional, with some key differences. The biggest difference is that a Roth IRA account does not allow you to deduct your contributions from your income tax, but the qualified distributions are tax-free. Roth accounts use after-tax dollars, meaning you pay income tax before making any contributions. Your funds can be withdrawn at any time, penalty-free. However, your earnings are still subject to the 10% penalty if you choose to withdraw them before age 59 ½. As the account grows, you do not face any taxes on your investment gains. In addition, there are no required minimum distributions (RMDs). If you don’t need some or all the funds, you can keep it in your Roth IRA without facing penalties. You can even leave the money to your heirs if you don’t end up needing it. There are still limitations to how much you can contribute each year, as well as income limitations to qualify. This flexible option may not be available to you if you have a modified adjusted gross income (MAGI) that is too high. Contributions are gradually phased out as your MAGI increases, up to a certain value, in which case you cannot contribute to a Roth at all.
Simplified Employee Pension (SEP) IRAs: SIMPLE and SEP IRAs are both benefits that can be instituted by an employer. While they cannot be opened by an individual, they function similarly to a traditional IRA with higher contribution limits, and they may allow for company matching. SEP is a retirement plan that an employer or self-employed individual can open, where the employer is allowed a tax deduction for contributions made to the fund. The employer makes contributions to each eligible employee’s SEP-IRA on a discretionary basis, and those contributions are vested immediately.
Vesting is an incentive program for employees that gives them benefits, usually in the form of stock options, when they have fulfilled a specified term of employment with their company. The benefits can be other assets, such as retirement funds. Vesting is a way for employers to incentivize their top-performing employees to stay with that company, as a common vesting schedule is three to five years. When it refers to retirement plan benefits, vesting gives employees the rights to employer-provided assets over time, such as matching dollars in a retirement fund on an increasing scale. The employee must stay with the company long enough to be eligible to receive these benefits.
Savings Incentive Match Plan for Employees (SIMPLE) IRAs: Also instituted by an employer, SIMPLE IRAs are retirement savings plans that can be used by most small businesses with 100 or fewer employees. Employers can choose to make a 2% retirement account contribution to all employees or make an optional matching contribution of up to 3%. These IRAs have minimal paperwork requirements, and the employer establishes the plan through a financial institution that will administer it. The startup and maintenance costs are low, and employers get a tax deduction for contributions they make for employees. However, the drawback of using SIMPLE IRAs is that the business owner cannot save as much for retirement as they might with other small business retirement plans, and these accounts cannot be rolled over into a traditional IRA without a 2-year waiting period from the time the employee first joined a plan, unlike a 401(k).