What is an IRA? Guide to Individual Retirement Accounts

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An individual retirement account (IRA) is one of the best retirement plans for people not covered by an employer-sponsored retirement plan.

An IRA is an account set up at a financial institution like Fidelity, Vanguard, Charles Schwab, Black Rock, etc. (I use Fidelity!)

In this post, you’ll learn about IRAs.

Disclaimer: I’m not a financial expert. All content provided is for informational purposes only. Please read my full disclaimer here for more info.

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What are IRAs?

IRA stands for Individual Retirement Account. It’s basically an investment but a mix of stocks, bonds, mutual funds, and other assets to limit losses. (1)

What does it mean exactly? IRAs are investments, but it’s retirement investments. Since it’s an investment, there are gains and losses. So, you don’t want to invest all your money in something that has ups and downs dramatically. These days most people invest in ETFs for their retirement savings.

Please note that not everyone can open IRAs. Most IRAs have eligibility restrictions based on your income or employment status. Here are income ranges for IRA eligibility.

Why invest in IRAs?

Many financial experts estimate that you may need up to 85% of your pre-retirement income in retirement. (2) An employer-sponsored savings plan, such as a 401(k), might not be enough to accumulate the savings you need.

For American workers, Social Security is part of the retirement plan, but it’s absolutely not enough. IRAs could be super helpful supplemental income in your retirement for sure!

The 3 Main Types of IRAs

Savings challenge printable here

Traditional IRA

Traditional IRA is a great option for people who want to reduce their taxable income by deducting contributions. (2)

Every year, you can put $6,000 into your Traditional IRA. ($7,000 if you’re age 50 or older) This money can save you a decent amount of money on your taxes. For example, if you’re in the 32% income tax bracket, for instance, a $6,000 contribution to an IRA would equal about $1,000 off your tax bill. (3)

You can take money out from your Traditional IRA at any time. However, your money and earnings (including dividends, interest, and capital gains) will be taxed as ordinary income.

If you withdraw it before turning 59 and a half, the U.S. government charges a 10% penalty and a state tax penalty may also apply. You may be able to avoid a penalty if your withdrawal is for qualified higher education expenses, qualified firm home purchase (lifetime limit of $10,000), certain major medical expenses, certain long-term unemployment expenses, disability, or death. (4)

In addition, you will need to file a Form 1040 and show the amount of the Traditional IRA withdrawal regardless of your age. (5)

You save tax when your tax bracket is high using a Traditional IRA. Pay tax when your tax bracket gets lower!

Roth IRA

Savings challenge printable here

Roth IRA is a great option for people who want potential earnings to be tax-free.

In general, the best investments for Roth IRA are those that generate highly taxable income such as dividends, interest, and short-term capital gains.

Every year, you can put $6,000 into your Roth IRA. ($7,000 if you’re age 50 or older) You will put after-tax money into your Roth IRA, so there is no tax-deductible. But earnings can grow tax-free, and qualified withdrawals are tax and penalty-free. For example, you don’t have to pay tax for your dividends, interest, and capital gains when you take out money from Roth IRA.

You can withdraw your money in Roth IRA anytime, tax and penalty-free. But you may have to pay taxes and penalties on earnings (dividends, interest, and capital gains) in your Roth IRA if you are age 59 and under. Please note that if you haven’t met the five-year holding requirement, your earnings will be subject to taxes but not penalties.

Same as Traditional IRA, you may be able to avoid a penalty if your withdrawal is for qualified higher education expenses, qualified firm home purchase (lifetime limit of $10,000), certain major medical expenses, certain long-term unemployment expenses, disability, or death.

Pay tax now and grow your money tax-free using Roth IRA. Get all potential growth tax-free.

Rollover IRA

Rollover IRA is a great option for people who centralized accounts for any former workplace 401(k)s. Rollovers mean in here, moving eligible assets from an employer-sponsored plan, such as a 401(k) or 403(b), into an IRA. For example, if you don’t have many options in your 401(k) and keep losing money, Rollover IRA could save some money. Because it provides you with more options like ETFs, bonds, stocks even cash positions.

Wrapping Up

Income stocks are really great ways to grow your IRA but don’t forget diversification. It can help reduce your portfolio’s risk so that one asset’s performance doesn’t affect your entire portfolio.

It’s your turn. Which IRA do you prefer and why?

References:

  1. CNN Money. What is an IRA? (2022, March 30).  https://money.cnn.com/retirement/guide/IRA_Basics.moneymag/index2.htm?iid=EL
  2. Fidelity. IRA Account Options, Benefits, & Investment Guidance. (2022, April 2). https://www.fidelity.com/retirement-ira/overview
  3. Forbes. Last-Minute IRA Contributions Might Lower Your Taxes. (2022, March 30). https://www.forbes.com/advisor/retirement/last-minute-ira-contributions/
  4. Retirement Topics – IRA Contribution Limits. (2022). https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
  5. IRS. Retirement Plans FAQs regarding IRAs Distributions Withdrawals (2022). https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-distributions-withdrawals

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