You might have heard about individual retirement accounts (IRAs) but know little about what they are or how they can help you reach your retirement goals. Instead of bogging you down with a lot of technicalities, let’s take a look at four basic IRA facts you need to know before you get started.

An IRA is a financial vehicle set up to help working people save for retirement. It has similar tax benefits 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.

Key Takeaways

  • There are annual limits as to how much you can contribute to an IRA, whether traditional or Roth.
  • 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 posttax funds, so your withdrawals go untaxed.

1. IRA Limits

For tax years 2019 and 2020 the IRS allows you to deposit up to $6,000 per year if you’re under the age of 50 and $7,000 per year if you’re 50 or older. You must also have earned income to contribute to an IRA, but that could include a spouse’s income if you’re married.

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 distributions, which is the term used to describe the withdrawals you make once you reach retirement age. 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

There are eligibility requirements for both types of IRAs. With the traditional IRA, if you’re also a participant in an employer-sponsored plan you can only take your contributions as a tax deduction if your earnings fall below certain maximums. In 2020 you must earn below $75,000 a year ($74,000 for 2019) if filing as single, or $124,000 ($123,000 for 2019) if married filing jointly, to be eligible to deduct IRA contributions. The phase-out range begins at $65,000 ($64,000 for 2019) for singles and $104,000 ($103,000 for 2019) for married couples filing jointly. If you earn within that range you can get a partial deduction.

According to the Vanguard Group, if your traditional IRA isn’t tax deductible, a Roth IRA is the better choice. With the Roth IRA, your contributions are never deductible and there are income limits. If you’re single and make more than $139,000 in 2020 ($137,000 for 2019), you aren’t eligible to open a Roth, and the income phase-out range begins at $124,000 ($122,000 for 2019). If you are married filing jointly, the figures are $206,000 and $196,000, respectively ($203,000 and $193,000 for 2019). If you are within the phase-out range, you can make a partial contribution. If you are below it, you can make the full annual contribution.

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. If you’re charged a 1% management fee, that could equate to a 30% lower balance over a 30-year period, so keeping fees to a minimum is key.

The Bottom Line

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.