All About IRAs – Individual Retirement Accounts

The importance of planning for your retirement is paramount, though all too often the vivid needs of the present take precedence over a blurry and far-off future. An Individual Retirement Account (also known in common parlance as an IRA) can constitute a vital part of your long-term financial security by helping to accumulate savings during your working years.

What is an IRA?

An IRA is a long-term savings account that individuals can use to build-up their nest egg for retirement. Unlike standard investment accounts, there are significant tax advantages that are part of the IRA package.

In essence, the purpose of an IRA is to incentivize users to save for retirement, similar to employer-offered 401(k)s. For those lacking this option, and even for those wishing to supplement their 401(k)s, an IRA can serve as an essential pillar of a retirement strategy.

How Does an IRA Work?

An IRA is an investment account that contains significant tax benefits designed to encourage individuals to save for retirement. Along with the tax breaks, there are restrictions on the amount you can contribute annually, while the ability to remove monies is also limited.

You can establish an IRA with a brokerage, bank, or other financial institution that engages in this type of work.

Once the money is in an IRA, you can invest it in all sorts of different assets. This can depend on your level of risk tolerance, and can vary from a conservative allocation strategy to a more aggressive approach.

Depending on the firm where you open your account, you can have a wide variety of options expanding beyond stocks, bonds, and mutual funds. Some IRA providers offer alternative investments such as real estate, peer-to-peer lending, or cryptocurrencies. The choice is yours, and will be determined by the options available at your desired firm.

When deciding where to open your IRA, pay attention both to the investment options as well as to the costs associated with your account. These include management and transaction fees, as well as mutual fund expense ratios. Because you will be holding on to these investments for long periods of time, even small differences in the fee structure and costs can add up to big sums of money.

Individuals can choose how much to devote to their plan every month or year. In 2024, the maximum contribution for those under 50 years of age is capped at $7,000 per year. (If you are over 50, you can contribute up to $8,000 per year.)

Putting monies into the IRA is one side of the equation. Taking them out is the other.

In order not to be penalized for an early withdrawal, the monies must remain in your Traditional IRA for at least five years and cannot be removed before you turn 59.5. If neither of these conditions are met, you will be penalized 10% when you take an early withdrawal. (This differs slightly between Roth vs. Traditional IRAs. See below the explanation below.)

There are exceptions when this penalty may not apply, such as when these monies facilitate a first-time home purchase or if other financial hardships occur.

Roth vs Traditional IRA: What is the Difference?

There are a couple of key distinctions between a Roth IRA and a Traditional IRA, which relate to contributions, withdrawals, and taxation.

Contributions: The maximum annual contribution limits for both Traditional and Roth IRAs are the same, but with a catch. For Traditional IRAs, there is no income limit. No matter how much income you earn, you can contribute up to the maximum amount every year.

For Roth IRAs, however, your maximum contributions begin to taper off and eventually reach zero if you are making above a certain level of income. In other words, if are earning above a specific level, you will not be able to directly contribute to a Roth IRA. The IRS publishes these numbers and limits on its website.

Withdrawals: The government wants to encourage you to keep your savings in your IRA, at least until you turn 59.5. For that reason, you will be penalized 10% if you remove your monies beforehand.

For Traditional IRAs, if you withdraw your funds before reaching the age of 59.5, you will be pay ordinary income taxes on these monies AND be on the hook for an additional 10% penalty. As an example, if you remove $1,000, these funds will be taxed as regular income tax and you will need to pay an additional $100 penalty.

Roth IRAs are composed of after-tax dollars, however, meaning that you have already paid taxes on these monies. You can therefore withdraw the contributions you have made before you are 59.5 without any penalty or tax. However, the monies you have earned will be subject to both taxation and the aforementioned 10% penalty.

Taxation: In practice, similarly to Traditional 401(k) accounts, the monies you devote to a Traditional IRA account are tax deductible. In other words, if your income is $70,000 and you contribute $4,500, you will only pay income taxes on $65,500.

For both Traditional 401(k) accounts and Traditional IRA accounts, you will pay taxes on the monies when you receive your payments, once retirement rolls around. These are called distributions, and they will be taxed as ordinary income.

When it comes to Roth IRAs and Roth 401(k) plans, however, the chronology is reversed. You will not receive a tax break on your initial investment. In the above example, regardless of how much you contribute to your Roth IRA (let us say the maximum of $7,000 for an individual under the age of 50), you will not receive a tax break.

The benefits, though, come much later.

Once you reach retirement age and begin to take distributions, you will not pay any taxes on the monies that you have accumulated. This includes capital gains and any dividends that were earned over time within your account.

Roth or Traditional IRA: Which Makes Sense for You?

Deciding between a Roth or Traditional therefore comes down to a couple of considerations that revolve around taxes, flexibility, and your current financial situation.

If you think that your tax bracket is higher now than it will be in retirement, it would make sense to go the traditional route. You will save on taxes now, but be on the hook for these costs later. On the other hand, those who believe that their tax obligations will be higher once they begin receiving distributions would be better off going with the Roth. You will pay now, and save later.

If you are in a higher income bracket, your choice will be made for you, as those making above a certain amount cannot contribute directly to a Roth IRA. The flexibility of a Roth IRA to remove funds may come in handy, though the idea of an IRA is meant to discourage early withdrawals.

Another important consideration, though, is your current financial status. If you are struggling to get through the month now–or are servicing high-interest debt–future benefits of the Roth might not be as worthwhile for you.

As you think about your tomorrows, another item to consider is the concept of Required Minimum Distributions. Roth IRAs (now) and Roth 401(k) plans (starting in 2024) will no longer have Required Minimum Distributions, which mandates that you must withdraw a certain amount from your retirement fund every year once you hit the age of 73 (barring a few exceptions). While this does not impact most individuals, it is another consideration to take into account.

It is always a good idea to speak with a licensed professional, who can help walk you through these different options.

Conclusion: IRAs and Your Future Retirement Plans

It is imperative to save for the future, and IRAs provide strong incentives to make this happen.

As you go through the process of thinking which option makes the most sense for you, remember that the act of putting money away on a steady and regular basis pays remarkable dividends over the years.

Through the magic of compound interest, the monies you invest will begin to earn their own monies, ramping up your wealth at a progressively higher clip. It is never too early (or late!) to begin putting monies away.

Whichever type of retirement savings account you eventually choose, an IRA can benefit you greatly in retirement, and help to make your golden years truly a golden period of time.

Learn money management, and use data-driven stock insights with TipRanks.