This article includes links which we may receive compensation for if you click, at no cost to you.
If you’ve ever read anything about personal finance, you’ve probably heard of an IRA or Individual Retirement Account.
But it’s easy to get scared off by what can seem like technical jargon – what is an IRA?
Simply put, it’s a type of account that helps you save for retirement while taking advantage of tax benefits. If you want to stand a chance of enjoying a comfortable retirement – or any retirement at all – then opening an IRA is a must.
What Is An IRA And How Does It Work?
When you deposit money into a conventional investment account, you’ll have to pay tax on the earnings you accrue when you withdraw them.
In contrast, when you put your money into an IRA, you’ll get a tax break in some form – although the precise mechanisms depend on the kind of IRA you open.
Although the rules and eligibility of IRAs differ, the overall idea of how they work is the same: you invest a portion of your income into your account, so the amount can grow over time and eventually be withdrawn later in life.
Along with having a choice between the type of IRA you open, you can choose from a few different providers. You could open your account with a bank, brokerage company, credit union, savings and loan association, or even a robo-advisory application.
Whichever you choose, you’ll need the following information:
- Social Security Number
- Contact Information
- Employment Details
Types of IRAs
There are several types of IRAs:
It might sound overwhelming, but some IRAs are for particular purposes; chances are, you’ll only be eligible for a few.
A traditional IRA is a great option for anyone who wants a quick tax break or who expects to be in a lower tax bracket for retirement due to how the tax benefits work.
When you contribute to a traditional IRA, you can deduct the amount straight off your tax return for that year, giving you the instant gratification of a smaller tax bill. The rules about exactly how much you can deduct are slightly complex and depend on your income.
- If you earn $63,000 or less, you can deduct 100% of your contribution
- If you earn up to $73,000, you’ll only be eligible for a partial deduction
- If you earn more than $73,000, you won’t be able to make any deductions at all
Investments, social security benefits, and child support don’t count as ‘income’ for an IRA.
Assuming you meet the income requirement, you can save $6,000 a year, or $7,000 if you’re aged 50 or above (but be aware that the exact amount you can save varies from year to year).
To open one, you must have earned taxable income that year and be 70.5 years old or younger. If you earn less than $6,000 a year, the maximum you can contribute is the amount you earned (e.g. $3,500).
Although a Roth IRA gives you an instant tax break, it doesn’t let you avoid tax altogether. When you eventually withdraw the money, you’ll be taxed on both the original contributions you made and everything you earned through interest. This means a traditional IRA is a bad idea for anyone who expects to earn more when they withdraw than they earn now.
Technically, you can withdraw your money from a traditional IRA at any point, but this comes at a cost. For anyone aged 59.5 or younger, you could face a 10% penalty, a and tax bill, for withdrawing early, so this should be avoided at all costs.
Just like the traditional IRA, a Roth IRA lets you save $6,000 a year, or $7,000 for those aged 50+. However, there are some very important differences.
Contributions to a Roth IRA aren’t tax-deductible, but when you retire, you won’t be taxed on your earnings or your original money. This means you’ll have to wait patiently to be able to reap the benefits of your investments, but it’s likely to be a smarter move in the long run since you’ll be paying taxes when the overall amount is lower and when your income is lower.
Another key difference is that there’s no penalty for early withdrawals with a Roth IRA, although there are some rules about taking money out. To find out about the differences and similarities between a traditional IRA and a Roth IRA in more detail, look here.
Unfortunately, there’s an income limit on saving for a Roth IRA – this is currently $137,000 for a single person or $203,000 for a couple – but you can get around this by opening a ‘backdoor Roth IRA’. A backdoor IRA lets you open a Roth IRA if you exceed the income limit, which is done by opening a traditional IRA and then converting it into a Roth IRA. It might sound strange, but it’s completely legal.
A SEP (simplified employee pension) IRA is for the self-employed and small business owners and works similarly to a traditional IRAs when it comes to taxation rules.
The main advantage of a SEP IRA is the fact that you can save much more – $56,000 a year – although you can’t contribute more than 25% of your salary.
If you have eligible employees, you must contribute the same percentage of their compensation to their IRA as you pay of your own compensation into your IRA. This means, if you contribute 10% of your income, you need to contribute 10% of your employees’ income. Employees can’t contribute to their own accounts.
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is specifically for small businesses, generally with 100 or fewer employees. It’s basically an alternative to a 401(k) for those with a smaller workforce.
A major difference between a SIMPLE IRA and a SEP IRA is that a SIMPLE IRA allows employees to contribute. Employees can invest up to $13,000 a year, and those aged 50 or over can add $3,000 more.
As is the case with a traditional IRA, the amount you contribute reduces your tax bill, but tax is charged upon withdrawal.
A rollover IRA lets you ‘rollover’ money from a different type of employer-sponsored retirement plan (as long as it qualifies) into a traditional IRA.
This is usually a 401(k) or a 403(b).
If you don’t work, but your partner does, the only way to get tax benefits from your investment is by opening a spousal IRA, which is based on the income of the working spouse.
The maximum annual contribution is $6,000 (or $7,000 for those aged 50 or older), and the total contributions of both partners can’t exceed the income of the working spouse.
A self-directed IRA may seem like a strange name for a voluntary account, but in this context, ‘self-directed’ means you’ll be able to choose the types of investments you focus on. Self-directed IRAs can be traditional or Roth IRAs.
You can then use your IRA to invest in stocks, bonds, ETFs or mutual funds. For example, you could choose real estate or specific companies. Unfortunately, not all brokers offer self-directed IRAs.
Which Type Of IRA Is Better?
The best type of IRA for you to open depends mostly on your personal and financial circumstances.
If you expect to be in a higher tax bracket in the future, putting your money into a Roth IRA is preferable, because you’ll avoid tax when you’re earning more.
Therefore, young people should generally opt for a Roth IRA, since earning potential peaks later in life. However, if you expect to withdraw when you’re retired and on a low income, then a traditional IRA could be better.
It’s also relevant that you don’t need to pay a fine to withdraw the money from a Roth IRA early, but you do for a traditional IRA. It’s not recommended to withdraw your money at all, but if you think it could be a possibility, then it’s best to opt for a Roth IRA.
The good news is that you don’t necessarily have to choose just one type of IRA; opening both a Roth IRA and a traditional IRA could be worth considering if you’re unsure what your financial circumstances will be in the future.
However, if you open multiple IRAs, your maximum contribution can’t exceed $6,000 across all of them.
The more specific types of IRAs are for people with more specific circumstances. If you’re a small business owner or unemployed with a working spouse, then your choice is made for you.
What Are The Best Places To Open An IRA?
You can open an IRA with any institution approved by the Internal Revenue Service (IRS), although brokers are the most popular. When deciding where to open an IRA, an important factor to consider is how much control over the investment process you want and how much you’re willing to spend.
If you want the most control possible, an online brokerage is the best option – perhaps even a self-directed IRA.
For those who just want a safe option that will look after their money for them, a robo-advisory platform is an economical alternative to an investment manager.
It’s also possible to open an IRA with a large bank, but this might mean more fees. If you manage your own account (or get a robo-advisor to manage it for you), then you’ll be able to keep more of the earnings of your investment.
Robo-advisors use computer algorithms to make investment recommendations, leveling the playing field, and giving standard millennials access to top-quality investment tools by automating the process.
Betterment is one of the top robo-advisor platforms and offers an affordable way to invest effectively. It offers traditional, Roth, and SEP IRAs.
There’s no minimum balance, fees are reasonable (there’s a management fee of 0.25%), and it’s easy to use. Using its intelligent algorithms, Betterment will establish your goals and risk preferences then recommend the portfolio that best suits you.
You’ll be directed towards ETFs, which include pieces of different stocks and helps to create a diversified portfolio. Vanguard ETFs are some of best and most affordable available. You can automate the investment process by using deposits to rebalance your portfolio.
The Tax Coordination feature automates asset location, which ensures you’re investing in the most tax-efficient way possible and ultimately leads to more returns. This means assets taxed at higher rates get put in tax-advantaged accounts like the IRA, while assets taxed at lower rates get placed in a taxable account. Of course, you’ll need to have multiple accounts with Betterment for this to work.
Acorns provides a novel way of saving for your retirement: you can invest your small change straight into an IRA. It’s a great way to start if you still find the world of investment terrifying and only have a little to invest.
All you need to do is connect your cards – every time you buy something with a connected card, Acorn will round up the amount spent and invest the leftover change.
You might not think it sounds like much, but all those coffees can add up. Like Betterment, the Acorns algorithm will point you towards ETFs. You can choose whether you want a conservative or risky portfolio; however, this isn’t the only way you can use Acorns to invest. You can also set up recurring contributions. Acorns Later (the name of the service) comes at the cost of $2 a month until you accumulate $1 million, and then the subscription becomes $100 per million per month. You can start by saving just $5 a month.
Robo-advisors are the best option for most people, but if you’re an active trader and want to have control over what you’re investing in, an online broker could be an option worth considering.
Vanguard offers traditional, Roth, rollover, SEP, or SIMPLE IRAs. The minimum amount to open is $1,000, although many of the funds require a $3,000 minimum investment, and there are no account fees.
Vanguard is known for its low-cost index funds. They claim to have an expense ratio of 83% lower than the industry average.
You can use these to create a diversified portfolio that handles asset allocations for you; you won’t need to worry about individual stocks, because an index fund is made up of a huge number of companies’ stocks. Alternatively, you can choose your own stocks; there are no sales loads and no sales commissions.
Vanguard also has its Personal Advisor Services, robo-advisor, for a management fee of 0.3% and an account minimum of $50,000.
Fidelity is one of the biggest investment management services in the world. They have some great features, including real-time analytics, their own robo-advisor called Fidelity Go, and research tools.
It also has low-cost index funds. There’s no account minimum, a free no-fee index fund, and target-date funds so you can tailor your investments to your retirement goals. You can open either a Roth, rollover, or a traditional IRA.
What is the benefit of an IRA?
There are lots of benefits to an IRA. Obviously, they provide a great way of saving money for retirement. It’s now estimated that most people need up to 85% of their pre-retirement income for retirement; this is a huge amount to save up, and a 401(k) might not always be sufficient.
One of the major perks is the tax benefits. Whether you make deductions from your tax now or save yourself from being taxed on future income, you shouldn’t miss out on an opportunity to cut your tax bill.
They’re also very flexible. Because there are so many different types of IRAs and so many different providers you can open an IRA with, there’s sure to be something that suits you and your financial situation.
Are IRAs a good idea?
Saving and investing should be priorities for everyone, and one of the best ways to do this is by opening an IRA. Social security and employer pensions are no longer a guarantee for Millennials when they retire, so the only way to guarantee your wellbeing later in life is to save for it independently. Opening an IRA may seem like a luxury, but it’s truly essential.
The only exception is people who have access to a generous savings scheme at their workplace, for example, a matched contributions 401(k). If you find yourself in this situation and have limited resources to invest, you should prioritize your workplace scheme above an IRA to maximize your earnings.
Is an IRA and 401(k) the same thing?
IRAs and 401(k)s are different. IRAs are for individuals to invest, while 401(k)s are workplace schemes. In practice, traditional IRA and 401(k)s work very similarly, although a 401(k) has higher tax-free contribution limits.
It’s advisable to combine your IRA with a 401(k) or another workplace savings plan. However, be aware that having a retirement plan at work limits the amount you’ll be able to deduct from your IRA.
You should generally contribute to your employer’s plan before you fund your IRA – especially since most employers match contributions, so it’s a way to get ‘free’ money.
Is An IRA A Good Investment?
It’s essential you start saving now to ensure a comfortable, independent retirement – the sooner, the better.
One of the best ways to save money for retirement is by using an IRA, and thanks to the innovative robo-advisory apps, it’s never been easier to set one up and start investing.