September 11, 2017

What is an IRA? And why should you have one?

An Individual Retirement Account (IRA) is a broad category of retirement accounts providing significant tax savings. IRAs are important assets for building wealth and shielding away taxes. If you are eligible, you should be taking advantage of the benefits of an IRA account.

An IRA is less account and more collection of investments. They are provided by many financial institutions (Vanguard, Fidelity, Schwab) and funded by securities like stocks, bonds, and mutual funds.

Some IRAs such as a Traditional IRA or a Roth IRA can be opened by individuals.

Employers can provide IRA accounts benefitting employees like Simplified Employee Pension (SEP) IRAs and Savings Inventive Match Plan (SIMPLE) IRAs.

Why have an IRA?

The simplest answer is to save money by either (1) reducing taxes on your income or (2) defer taxes on investment growth.

There are other benefits as well.

  • You can lower your taxed income (and possibly your tax bracket): Through the Traditional IRA, provided you meet the requirements, you can deduct your contribution against your income up to $5,500 (or $6,500 if you 50 years or older).
  • Hardship distributions: Typically early withdrawals are taxed as income, and possible may have an additional 10% penalty tacked on, with the exception of hardship distributions. Examples of hardships are medical expenses for you or your spouse, education expenses for a child, payments necessary to avoid eviction, and funeral expenses.
  • Down payment on a home: Homebuyers can withdraw penalty-free up to $10,000 towards a down payment.

Who is eligible?

Anyone under the age of 70.5 can contribute to an IRA in some form. The level of contribution often depends on your income level and whether you’re enrolled in an employer-sponsored retirement accounts like a 401(k) or a 403(b).

There are a handful of limitation however and usually involve:

  • Age: Most IRAs will have a limit of 70.5 to be allow contributions. Some like the Roth and Traditional will allow "catch up" contributions after 50.
  • Enrollment in an employer-sponsored retirement account: The Traditional IRA has limits on contribution if you are already enrolled in a retirement account from your job
  • Income limits: Both Traditional and Roth IRAs have limits on contribution if your income exceeds a certain amount
  • Business ownership or freelance income: Both the SIMPLE and SEP IRAs are created by business owners and freelancers. Roth and Traditional IRAs can be created by individuals.

What are the different types?

There are several types of IRA accounts, with Roth IRAs and Traditional IRAs the most popular:

Roth IRA

A Roth IRA allows money post-taxed income to be invested, allowing its growth and withdrawal after the age of 50 to be tax-free.

Eligibility of a Roth IRA is limited by your income level. As of 2017, individuals making less than $118,000 (or less than $186,000 if married and filing jointly) can contribute the full $5,500 per tax year. If you are over than 50, you can contribute $6,500 as a form of "catch up."

If you income is greater than $133,000 ($196,000 for couples filing jointly), you are not allowed to contribute. However, folks in this income range can use the Backdoor Roth IRA method.

If your income is between these two, you are allowed a partial contribution.

Traditional IRA

A Traditional IRA allows pre-taxed money to be invested. Growth is also tax-free but the withdrawal is taxed at your income level.

Eligibility is not limited by income. However, it is limited based on your existing enrollment of an employers sponsored retirement account like a 401(k) or a 403(b).

There are lesser common IRAs which we’ll cover too:

SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is established by employers and self-employed individuals (like those with sole proprietorships and partnerships). Similar to the Traditional IRA, the SIMPLE IRA allows pre-tax contribution to the account and withdrawals are taxed at your income level.

Compared to the Traditional and Roth IRAs, the most popular, a SIMPLE IRA may allow employees to contribute past the $5,500 limit.

SEP IRA

Like the SIMPLE IRA, a Simplified Employee Pension IRA is established by an employer (and not an individual like the Traditional and Roth IRAs).

A SEP IRA can be a great option for business owners, particularly small businesses with one or more employees or those with freelance income. SEP IRAs can be used to provide retirement benefits with no significant costs if the business owner does not have any employees. For any employees, they must be provided the same benefits as the business owner.

Contributions and withdrawals are similar to a Traditional IRA. Pre-tax money is contributed and is not taxable until withdrawn.

The SEP IRA is not limited to $5,500 like the Traditional and Roth. For 2016, owners can contribute the lesser of 25% of income or $53,000.

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