What is an IRA?
An Individual Retirement Account (IRA) is a retirement savings account that provides unique tax advantages to individuals. The IRA was created to incentivize people to save for retirement. It can be opened through a traditional retail bank, online brokerage, or investment firm.
401(k) versus IRA
Well then what’s the difference between a 401(k) plan and an IRA? The difference is in who sets up the retirement account.
Anyone can set up an IRA. But a 401(k) is normally set up by an employer who then contributes to the employee’s 401(k) plan. These employer contributions are deducted from the paycheque of the employee. Some employers will also match their employee’s contributions to the 401(k) plan.
A 401(k) plan has higher contribution limits tha an IRA. But 401(k) plans offer a smaller range of financial products that the employee can choose from.
Who is Eligible for an IRA?
Anyone with taxable income can open and contribute to an IRA. Even if the individual already owns other retirement accounts such as a 401(k) account through an employer, he can open an IRA.
What Can You Contribute to an IRA?
When you open an IRA, within that IRA, you can invest in a wide variety of eligible financial product such as mutual funds, stocks, bonds, and exchange traded funds (ETF), commodities, and real estate. The individual can manage his IRA assets himself in a Self-Directed IRA (SDIRA).
Generally, highly-risky and illiquid investments such as startup company shares are not eligible for an IRA.
And there are limits on the amount of money that the individual can contribute to the IRA in a given 12 month period.
When Can You Withdraw from Your IRA?
As mentioned above, an IRA is designed to incentivize individuals to save for retirement. As such, it tries to disincentivize individuals from withdrawing from the IRA before retirement. Therefore, if any withdrawals are made before age 59½ years old, an early withdrawal penalty of 10% is charged to the individual.
However, if the withdrawal is for a first-time home purchase or educational expenses, the penalty is waived.
Types of IRA
Now, let’s look at the different types of IRA :
Traditional IRA
This is the simplest and most common form of IRA. Contributions to a traditional IRA are tax-deductible. This means that any amount that is contributed to an IRA is deducted from the individual’s taxable income in the year that the contribution was made.
A simple example would be, let’s say you contributed $1,000 into an IRA in 2021, your taxable income decreases by $1,000 for that 2021 tax year. Then, when you withdraw from your IRA later during in retirement years, the withdrawn income is taxed at your ordinary income tax rate at that time. Thus, your money grows on a tax-deferred basis in a traditional IRA.
And if you expect to earn lower income during retirement because you are no longer actively employed, then this income tax rate in your retirement years would be lower than the income tax rate during your active years. In this way, you save money in taxes.
For 2021 and 2022, the annual individual contributions limit to a traditional IRA was $6,000. But if you are 50 or older, you can contribute up to $7,000 per year. The extra $1,000 (over $6,000) is a catch-up contribution.
If you have no retirement plan such as a 401(k) set up with your employer, your traditional IRA contributions are fully deductible. But if you or your spouse have a retirement plan at work, your modified adjusted gross income (MAGI) determines how much of your traditional IRA contributions can be deducted.
In 2021, if you are single or file as head of household and have a retirement plan at work, your traditional IRA contributions are fully deductible if your MAGI is below $66,000. If you are married filing jointly, your MAGI must be less than $105,000. From there, you begin to lose deductions as your MAGI increases.
For 2022, the IRS changed the income phaseout range for deducting contributions to a traditional IRA for investors with retirement plans at work. For married couples, the phaseout range increased from $105,000 to $125,000 in 2021 to $109,000 to $129,000 in 2022. And for single taxpayers or heads of households, increases from $66,000 to $76,000 in 2021 to $68,000 to $78,000 in 2022.
If you contribute to an IRA and you are not covered by an employer-sponsored retirement plan, but your spouse is covered by an employer-sponsored retirement plan, the phaseout range increases from $198,000 to $208,000 in 2021 to $204,000 to $214,000 in 2022.
Roth IRA
A Roth IRA is a unique type of IRA whose contributions are not tax-deductible.
If its contributions are not tax-deductible and the individual loses the tax advantages associated with an IRA, then why would anyone set up a Roth IRA?
Well, because the qualified distributions from the Roth IRA are tax-free. That is, after you pay taxes on your income, you contribute assets to a Roth IRA using after-tax income. And you do not have to pay any taxes on the investment gains from your contributions.
When you retire, you can withdraw from the account with no income taxes payable on the withdrawals. And, unlike a traditional IRA, you’re not required to withdraw any specific amount from the Roth IRA. You can contribute to a Roth IRA as long as you have eligible earned income regardless of your age.
Maximum contribution limits each tax year for a Roth IRA are the same as for a traditional IRA. But in order to prevent high-income individuals from using a Roth IRA as a tax shelter by parking large sums of money in a Roth IRA and withdrawing tax-free gains anytime they want, there are income limitations for contributing to a Roth IRA.
For single filers in 2022, the phaseout range is $129,000 to $144,000. For married couples filing joint tax returns in 2022, the phase-out range is $204,000 to $214,000.
SEP IRA
A Simplified Employee Pension (SEP) IRA is designed for self-employed individuals such as small-business owners and independent contractors to set up their own IRA since they have no employer.
The rules for a SEP IRA are the same as for a traditional IRA. In 2022, SEP IRA contributions are limited to 25% of compensation or $61,000, whichever is less.
Business owners who set up SEP IRAs for their employees can deduct their contributions on behalf of employees. However, the employees cannot contribute to these accounts, and the any employee withdrawals are taxed at the employee’s ordinary income tax rate.
SIMPLE IRA
Savings Incentive Match Plan for Employees (SIMPLE) IRA is intended for self-employed individuals.
In a SIMPLE IRAs (unlike a SEP IRA), employees can make contributions to their own accounts, and the employer is also required to make contributions. Both the employee and employer contributions are tax-deductible.
The SIMPLE IRA employee contribution limit was $14,000 in 2022. The catch-up limit for workers aged 50 and older was $3,000 for 2022.
Required Minimum Distributions (RMD)
From age 72, an individual with a traditional IRA must begin withdrawing income from his IRA. This is called a required minimum distribution or RMD. The RMD amount is calculated from the individual’s IRA account size and the life expectancy. The RMD is a required withdrawal. If the withdrawal is not made, the IRS may charge a tax penalty equal to 50% of the amount of the required distribution.
What Are the Benefits of an IRA?
The 2 main benefits that we already discussed above are tax minimization. And, of course, an IRA provides a source of income during the retirement years.
An IRA enables you to save for retirement in a tax-deferred manner. And the IRA can reduce your tax bill during the contribution period or during the retirement period.
And the Federal Deposit Insurance Corporation (FDIC), which is a US government agency that provides protection when a financial institution fails, covers up to $250,000 per IRA account.