Perhaps you've heard about individual retirement accounts (IRAs) but know little about what they are or how they can help you reach your retirement goals. To get you started, let's take a look at four basic facts about IRAs.
An IRA is a financial vehicle that is designed to help working people save for retirement. Its tax benefits are similar to an employer-sponsored qualified retirement plan, such as a 401(k) or 403(b). If you have access to both, it's a good idea to save in both types of plans so that your savings are diversified. What's more, not all employers offer plans, so it's useful that there's another tax-advantaged way to save that doesn't depend on your employer.
- There are annual limits as to how much you can contribute to an IRA, whether it's a traditional or Roth IRA.
- With a traditional IRA, your contributions are made with pretax funds, but your eventual withdrawals will be taxed.
- With a Roth IRA, your contributions are made with post-tax funds, so your withdrawals are not taxed.
1. IRA Limits
For 2020, the Internal Revenue Service allows you to contribute as much as $6,000 per year if you're younger than age 50 and $7,000 per year if you're 50 or older. You also must have earned income to contribute to an IRA, but that could include a spouse's income if you’re married and file jointly.
2. Types of IRAs
There are two different types of IRAs: traditional and Roth. The traditional IRA doesn’t require that you pay taxes on your gains until you start taking required mandatory distributions (RMDs). As of 2020, the IRS increased the age at which you must begin taking RMDs, to 72 from 70½. The traditional IRA keeps more money in your account over time, and that allows the money to compound at a faster rate.
The Roth IRA requires that you pay taxes now, at your current tax rate. This allows your earnings to grow tax-free, and if you anticipate being in a higher tax bracket in the future, the Roth is probably your best choice.
If you earn above a certain amount, you cannot contribute to a Roth IRA.
3. IRA Eligibility
With the traditional IRA, the deductions for your contribution amounts are limited if you're also covered by an employer-sponsored plan. For 2020, individual taxpayers earning $65,000 or less ($104,000 for married couples) can take a full deduction. A partial deduction is available if you earn more than $65,000 but less than $75,000 (more than $104,000 but less than $124,000 for married couples). If you earn over those amounts no deduction is available.
If your traditional IRA isn't tax-deductible, then a Roth IRA is the better choice. With the Roth IRA, contributions are made with after-tax dollars and there are income limits. Individuals earning less than $124,000 per year can contribute the full amount ($196,000 for married couples filing jointly). You are permitted to contribute a partial amount if your income is greater than $124,000 but less than $139,000 (greater than 196,000 but less than $206,000 for married couples). If you earn over these amounts, then no contribution is permitted.
4. IRA Costs
In order to open an IRA, you'll need a bank or an investment broker. Some discount brokers offer no-fee IRAs other than the commissions charged to buy and sell within the account. Other brokers will charge a yearly management fee, even if they aren’t managing the account for you. Look for a no-fee IRA. A 1% management fee can significantly cut into your balance over a 20-year period, so it's important to keep fees to a minimum.
Whether it’s a Roth or traditional IRA, get started. The money that is sitting in your savings account earning little to no interest could work harder for you in an IRA with safe investment choices. Don’t know how to invest the money? Ask a fee-only advisor for some help. Many are happy to charge you a one-time fee and a fee for an annual consultation.