Posted By Ziga Breznik, Last updated: May 3, 2020
Most of us want to save for our retirement in some sort of retirement plan. Many people contribute to employer-sponsored retirement plans, such as the 401(k) plan or the 403(b) plan. These plans are paid into by both the employee and their employer, and the funds can grow tax-deferred. While these plans work for a lot of investors, they are not ideal for everyone, and for many people an alternative option is preferable.
The most popular alternative to these employer-sponsored plans is the IRA, or Individual Retirement Account. There are different types of accounts that can be opened, and a wide range of financial institutions that offer services and act as IRA custodians. In this article, we will explore what exactly IRAs are, how they work, and if they are the best retirement plan option for you!
Individual Retirement Accounts were established by the federal government in 1974. They were established as part of ERISA (the Employee Retirement Income Security Act). IRAs were designed for individuals to make savings for their retirement on a tax-deferred basis – meaning that funds contributed are not taxed (unlike other income) until it is withdrawn on retirement. The theory behind this idea is that the funds will grow in value by an amount greater than the amount of tax deducted on withdrawal. In most cases, contributing to an IRA works out as more profitable to the investor than simply putting the funds aside in a savings account or in cash.
There are different types of IRA which we will come to later, but this original form – known as the “traditional IRA” – is the most common. In contrast to plans such as the 401(k), they are not sponsored by the investor’s employer – the investor must first qualify before opening it, and make all contributions themselves.
We will come to the qualifications later, although they are simple enough that IRAs are very widely used! One reason that many investors opt for a traditional IRA over an employer-sponsored plan is that there tends to be a much wider range of investment choices (there are some exceptions which we will cover later!).
There are various benefits over other plans. The most obvious are the tax deductions – all contributions to a traditional IRA are fully tax-deductible (if your employer does not offer a qualified retirement plan). There are also no income limits – anyone earning an income is eligible to participate, however not everyone is eligible for tax deductions. If you are eligible for tax deductions, it allows your contributions to grow tax-deferred basis so that you can withdraw your funds during your retirement, when you will most likely be in a lower income tax bracket.
Another benefit is the security – contributions to an IRA are protected from creditors, and assets can be passed onto beneficiaries after the death of the account holder.
You can set up an account even if you already have another retirement plan! One thing to bear in mind with this, however, is that contributions may not be entirely tax-deductible if you have more than one plan.
As with any retirement plan, there are potential drawbacks to be aware of. These IRAs are subject to required minimum distributions (RMDs), meaning that there are minimum amounts that the investor must withdraw annually after retirement. The rules around IRA RMDs can be found in detail here. In addition, if you withdraw funds before the age of 59 and a half, these withdrawals may be subject to an IRS tax penalty of 10%.
Traditional IRAs are also subject to a limited contribution period – you are not permitted to make contributions to the account after the age of 70 and a half. Maximum contribution limits are also applicable (we will explore these in more detail later).
There are other types of IRA:
There are also options within a traditional IRA to make spousal contributions – married taxpayers can both contribute, even if one person is not working or is on a low income. More information on a spousal IRA can be found here.
The difference between a traditional IRA and a Roth IRA – another very popular form of IRA – is that unlike a traditional IRA, with a Roth IRA contributions are not tax-deferred. This means that income must be taxed before it is contributed into the account, but then on withdrawal of funds, no tax is applied to these funds as it has already been paid.
Essentially, the traditional IRA and the Roth IRA simply swap when taxes are paid – before or after. Which option is best for you is dependent on whether you expect your tax bracket to be higher or lower during your retirement.
The other thing to bear in mind is that Roth IRAs are not subject to RMD rules like traditional IRAs are.
You can choose between various investment options, and the range is usually far greater than with employee-sponsored retirement plans. Assets such as stocks, bonds, and mutual funds are the most popular, although others are available and worth researching. Although investment choices are greater, there are some exceptions (for example a precious metals IRA account through a rollover – an increasingly popular investment choice, is not currently allowed by the IRS to be kept as a traditional IRA asset), and different IRA custodians will have different limitations also.
Traditional IRAs qualifications are quite simple. You must earn taxable income, be under the age of 70 and a half, and not participate in an additional employer-sponsored plan. This makes this plan versatile and available to a wide range of investors! Depending on your income level, your contributions may or may not be tax-deductible.
There are a few IRS rules applied to a traditional IRA, such as the restriction on taking loans from the account, or investing in precious metal bullion or real estate. More rules are detailed below:
If you are below the age of 50, annual contributions must not exceed $5,500, or $6,500 if you are over 50.
You can roll over funds between financial institutions without any tax penalty – however, this is limited to once a year. Funds can also be used to fund a self-directed IRA.
Withdrawals are mandatory from age 70 and a half (the same age at which further contributions are prohibited). Taking withdrawals before age 59 and a half may also incur a 10% tax penalty from the IRS – although there are certain exceptions, which can be found on the IRS website.
As long as your employer does not offer a qualified retirement plan, your contributions are fully tax-deductible. However, depending on your filing status (e.g. if you earn no more than $56,000 annually, or a combination of no more than $89,000 between a married couple) and income threshold, you may still be eligible for tax-deductible contributions even if you are part of an employer-sponsored plan!
There is no perfect retirement plan that suits every investor. You should take into account various factors such as income, predicted future tax bracket, etc. However, generally speaking, it is best suited for investors who are looking to reduce their taxable income during their working life.
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