The Basics of IRAs: What You Need to Know to Start Investing

One of the most significant financial goals anyone has in their life is saving for retirement. As soon as people enter adulthood, they start getting the message about how important it is to start saving for retirement as soon as possible. But starting to work toward that goal can feel very overwhelming, especially when you have so many other financial obligations to take care of at the same time.

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Once you have a chance to start getting serious about your retirement savings, you have the challenge of figuring out how you want to start saving. There are all sorts of different investment options to help you get there and IRAs are just one of them.

What is an IRA?

IRAs are an investment method intended to help people save money for their retirement in a way that can provide some tax benefits. With an IRA, you can use your money to invest in things like stocks, bonds, and certificates of deposit, which can help the money you’ve saved grow faster than it would by being kept in a regular savings account. While some types of retirement savings options, like a 401(k), are only available through an employer, people can open IRAs on their own through banks or investment brokers.

In 2020, the annual contribution limit for most types of IRAs is $6,000 for people under the age of 50 and $7,000 for people 50 years old or older. These limits are set by the IRS and may change over time.

If you’re interested in opening an IRA, it’s important to understand that there are several different types of IRAs out there and which type is right for you can depend on a lot of different factors.

Traditional & Roth IRAs

Traditional IRAs and Roth IRAs are the two most common types of IRAs and the key differences between the two involve the ways contributions and withdrawals are taxed. In many cases, contributions made to traditional IRAs are tax deductible while contributions to Roth IRAs are not. On the other hand, the withdrawals from traditional IRAs are taxed while withdrawals from Roth IRAs aren’t.

Traditional IRAs are a widely popular investment option because virtually anyone can open one (as long as you’re under the age of 70½ and are either earning taxable income or have a spouse who is) and they can help reduce your total taxable income. While they’re a popular way to save money on taxes, it’s important to note that contributions to traditional IRAs aren’t always tax deductible. If you have a retirement savings account through your job, you can have an IRA in addition to that and you can make contributions to both accounts. However, the total amount of tax-deductible contributions to your IRA may be reduced or completely eliminated depending on your income and how you file your taxes.

While almost anyone can open a traditional IRA, Roth IRAs come with stricter rules. The amount of money you’re able to contribute to a Roth IRA decreases once your modified adjusted gross income (MAGI) crosses a certain threshold. If your MAGI crosses another threshold, you’ll become ineligible to contribute to a Roth IRA all together.

SIMPLE & SEP IRAs

If you’re self-employed or own a small business, SEP and SIMPLE IRAs are two types of IRAs to be aware of.

SEP and SIMPLE IRAs can both benefit those who are self-employed, but they can also be used by small-business owners as a way to contribute to their employees’ retirement savings. However, there are some big distinctions between the two in that regard. With a SIMPLE IRA, employers are able to contribute up to 3% of an employee’s pay to an IRA and an employee can also defer part of their salary into the account as well. But if an employer sets up a SEP IRA for themselves and their employees, the employees are not allowed to defer part of their pay into their IRAs, only the employer.

SEP IRAs come with the benefit of having a substantially higher annual contribution limit than other types of IRAs. In 2020, this limit was up to 25% of your total compensation or $57,000, whichever amount is lower. SIMPLE IRAs also have a higher annual employee contribution limit than other types of IRAs; $13,500 for those under 50 in 2020. But while other types of IRAs have an increased annual contribution limit for those who are over the age of 50, SEP IRAs do not offer that benefit. SIMPLE IRAs, on the other hand, do allow people 50 and older to save up to an extra $3,000 annually.

Other Common Types of IRAs

Rollover IRAs

Over time, people often end up with funds from retirement accounts that were started at jobs they no longer have and people aren’t quite sure what to do with them. A rollover IRA gives you a way to take those retirement savings accounts and turn them into an IRA. Not only does this help consolidate those accounts, you may be able to do so while maintaining their tax-deferred status if those funds are transferred through a direct rollover. If you receive a direct payout of the money in those old accounts instead of doing a direct rollover, there is a 20% tax penalty if it’s not re-deposited into a new IRA within 60 days.

There is no limit on the amount of money that can be put into rollover IRAs, but if you choose to roll any of those funds into a Roth IRA, those funds will have to be taxed.

Spousal IRAs

If you’re married and one partner doesn’t work, a spousal IRA is an option that benefits the non-working partner. They can also be an option if one partner in a marriage earns a very low income. A spousal IRA is simply a separate traditional or Roth IRA from the earning partner’s IRA which the earning partner contributes to on behalf of their spouse. To qualify for a spousal IRA, a married couple must file their taxes jointly.

When Can You Withdraw Money from an IRA?

One reason why people are often hesitant to invest their money is because they’re worried that something might come up and they might need access to that money before they’re supposed to use it. After all, anyone can have their financial situation change without warning. When you have an IRA, you can technically withdraw funds from it at any time, but it’s extremely important to understand that there may be penalties for doing so before you’re supposed to.

Generally speaking, you can start withdrawing from an IRA without penalty once you’re at least 59½ years old. If you have a traditional IRA, any withdrawals made after that time will be taxed as they’re supposed to be, but that’s it. With Roth IRAs, you not only need to be at least 59½ years old, you also need to have had your IRA for at least five years.

If you need to access funds from a traditional IRA before you’re 59½ years old, you will be hit with a 10% penalty in addition to having the money you withdraw being taxed as it normally would be. Roth IRAs can be a little more forgiving if you need to take funds out early. However, it’s very important to be sure that you withdraw less than you’ve contributed to it. If you start withdrawing your earnings on a Roth IRA before you’re 59½, you’ll be penalized 10% just as you would with a traditional IRA.

However, the 10% penalty can be waived if you’ll be using the funds for one of the following reasons:

  • Covering the expenses associated with a sudden disability
  • Medical expenses that are greater than 10% of your adjusted gross income if you’re under 65 or 7.5% of your adjusted gross income if you’re over 65
  • College expenses for yourself, a spouse, a child, or grandchild
  • Purchasing your first home (Up to $10,000 can be used without penalty)
  • The money is being withdrawn by your estate or the beneficiary of your estate after your death

For those with SIMPLE IRAs, the 10% tax penalty also applies if you need to withdraw funds from it before the age of 59½. But SIMPLE IRAs are another type of IRA where you have to think about how long you’ve had it before withdrawing funds from it. If you withdraw money from a SIMPLE IRA while you’re under 59½ and you’ve had your IRA for less than two years, the 10% penalty increases to 25% unless the funds are being used for one of the previously listed reasons.

Choosing the Right IRA for You

Even with so many IRAs that are intended for very specific purposes, figuring out which ones (or which ones) are best for you isn’t always easy. Each option has its advantages and drawbacks and there is no “one size fits all” approach to take. For example, according to USC Credit Union, a Roth IRA may be a more effective option than a traditional IRA if your contributions to a traditional IRA wouldn’t be tax deductible anyway. Roth IRAs can also be worth considering if it’s likely that you will be in a higher tax bracket by the time you retire. But for many people, the upfront tax benefit of a traditional IRA is more advantageous for them.

Wondering how a Roth IRA would compare to a traditional IRA for you? Try an IRA comparison calculator. For more help determining which IRAs would be best for you, a financial advisor will be able to help you find a solution that works best for based on your unique needs.

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