Individual Retirement Account (IRA)

IRAs: What You Need to Know

Investment experts have sought out new ways to help investors like you have more investing options. It is well known that a lot of people invest for different reasons, and there are several investment vehicles that suit individual investing preferences one of which is the IRA. IRA investments rally around retirement savings account. It has to do with putting some money away for a really long time maybe twenty years or twenty-five years for the sole purpose of funding your retirement plan in the future. Think of it as the younger you sending money to the older you. Of course, you can have a regular savings account where you deposit maybe $5000 monthly which would amount to $60,000 yearly and $1.2 million by the end of twenty years. The difference between investing through an IRA and regular savings is that, just like all investments, IRAs also come with interest rates which may differ according to investment firms.

Definition of IRA

IRA which means Individual Retirement Arrangement or Individual Retirement Account is a type of account created specifically for the purpose of saving for retirement. This type of account has some tax benefits attached to it. The benefits are usually dependent on the type of IRA that is involved either the traditional IRA or the Roth IRA. IRAs are majorly of two types the traditional IRA and Roth IRA. The other types of IRAs are SEP IRAs and SIMPLE IRAs which are specifically designed for small business owners, freelancers, and self-employed. We’d properly discuss them later in the article.

IRA holds other investment benefits beyond making yearly contributions. IRA lets investors also invest in stocks, bonds, Certificates of Deposit, savings account, and other assets if they wish. IRAs that offer stocks and bonds investment would be preferable for investors with long-term retirement goals. Closely associated with the IRA is the 401(k) which also provides similar services as the IRA. IRA contributions can either be made individually or jointly for married couples.

What’s the Difference Between an IRA and a 401(k)?

Another retirement savings plan available for employees is the 401(k) which is usually dependent on an employer’s retirement plan. Workers in the private sector, freelancers, or employees of small businesses can also partake in a retirement savings plan through an IRA. Both the IRA and 401(k) are retirement accounts. While IRAs can be opened by individuals with a steady income from a tax-paying job, 401(k) is usually employer-based, that is, the plan can only be initiated by an employer. Though both plans offer tax benefits, 401(k) is able to cap out $19,000 yearly due to its high contribution limits compared to IRA which caps out between $6000 and $7000 (for investors aged 50 and above) from its yearly contributions. In as much as just anyone can open an IRA, there are still basic requires that determine eligibility one of which is an income source that complies with tax regulations, and not an income source from investments or social security. You can still save in IRA even with an existing 401(k) plan at your workplace.

Types of IRA

As mentioned earlier, there are majorly two types of IRAs—traditional and Roth. There are also other types of IRAs—SEP, SIMPLE, Backdoor Roth, Inherited, Spousal, and Self-directed IRAs which all fall within the two major types. 

Traditional IRA

A traditional IRA offers investors tax advantages—that is allowing them to channel pre-tax income towards other investments that have the ability to grow tax-deferred—thereby, encouraging tax deductions. For individuals looking to reduce their tax bill, the traditional IRA is ideal. For example, if your total annual income is $40,000 and your IRA annual contribution is $6000 per year, contributing to a traditional IRA would technically exclude the $6000 IRA contribution leaving $34,000 as your taxable income for the year.  To eligible to take advantage of tax-deductions through traditional IRA contributions certain conditions have to be considered as anyone can make contributions to a traditional IRA but not everyone can deduct contributions. If a holder has both a traditional IRA and a 401(k) plan, there is a good chance that the IRS would limit the number of the holder’s contributions that can be deducted from taxes. The traditional IRA contribution limit for 2020 is $6000 and $7000 if you are 50 and above.

Once IRA contributions have been received, the service providers which are mostly brokerages and commercial banks directed the invested funds into different investment vehicles as specified by the owner based on available offerings as well. Account-holders are able to contribute pre-tax dollars to an IRA that can grow tax-deferred until the stipulated retirement plan. Retirement withdrawals are done at the age of 59 ½ or above. The maximum age allowed for investing in a traditional IRA is 70 ½, “$6,000 the maximum amount an individual under age 50 can contribute to a traditional IRA for the tax year 2019. This limit remains unchanged for the 2020 tax year.”

The perk about the traditional IRA is that there are no income limits to opening and contributing to its accounts. However, any attempt at early withdrawal before the stipulated time would attract a 10% early withdrawal fee and outstanding taxes. At the due time of withdrawal (retirement), the withdrawals will be taxed based on your current income tax rate with the exclusion of capital gains or tax dividends. Still, there are a few permissible exceptions to the early-withdrawal rule the exceptions include:

• The sudden death of the holder after which funds would be withdrawn and directed to the holder’s beneficiary.

• The use of the distribution to purchase or rebuild the holder’s first home or that of a recognized family member

• If the holder’s distribution is also part of a SEPP

• Use of assets to fund the holder’s higher-education

• Distribution of assets to pay IRS levy

• Holder becomes disabled before distribution

• Medical purposes

TRADITIONAL IRA INCOME LIMIT FOR 2020 (if you have an already existing retirement plan at work)

Roth IRA

The Roth IRA is kind of the opposite of traditional IRA in the sense that Roth IRA does not offer yearly tax deductions on every contribution, but on retirement, taxes will not be deducted per distribution. “A Roth IRA is a tax-advantaged, retirement savings account that allows you to withdraw your savings tax-free.” With Roth IRA you can make withdrawals at any time without fear of getting penalized. Roth IRA can double as a retirement savings account and regular savings account for the funding of individual goals before retirement. The major difference between the traditional IRA and the Roth IRA is basically how they are taxed. For the traditional, the taxes are taken during distribution, while for Roth IRAs taxes are deducted during contributions. Asides the benefit of a contributor’s money growing tax-free in a Roth IRA, a holder can still make contributions even past the age of 70 ½, so long as the holder still has a steady flow of income. Roth IRA accepts contributions for different sources such as transfers, regular contributions, rollover contributions, and spousal IRA contributions, as preferred by the holders. Roth IRA contributions can be made in assets or securities, stocks, bonds, mutual funds, ETFs, etc., but regular contributions must be made either in cash or checks.

Roth IRA contributions are not for individuals or married couples who earn a lot of money as the expected maximum income amount for individuals is $139,000 annually, and $206,000 for married couples as of 2020. The annual contribution amount for the Roth IRA is also $6000 for individuals and $7000 if you are 50 and above for the 2020 tax year.

ROTH IRA INCOME LIMITS FOR 2020

Other types of IRAs—SEP IRAs and SIMPLE IRAs.

SEP IRA and SIMPLE IRA are other types of retirement plan that concerns a business owner or self-employed. They are similar to the traditional IRA but are differentiated by their high contribution limits.  For simplified employee pension, SEP employers are eligible to establish a SEP plan and are allowed tax deductions for every contribution made to the SEP IRA, alongside allowed to make contributions to eligible employees SEP IRA when necessary. While the SIMPLE IRA also referred to as Savings Incentive Match Plan for Employees is a retirement savings plan accessible to businesses with at most 100 employees. Under this type of IRA, employers can either decide to make an optional 3% matching contribution to all employees’ retirement accounts or a 2% contribution to all employees’ retirement accounts. This type of IRA allows for employees to make an annual contribution of $13,000 and $13,500 as maximum contribution amounts. While for contributors above 50 an extra $3000 contribution is permitted, amounting to a total of $16,000 or $16,500 annually. Each year has its contribution limits. The figures stated are for the 2020 taxable year, and are bound to change in the coming year. 

Backdoor Roth IRA: This has to do with the conversion of a traditional IRA to a Roth IRA. This usually occurs in the case of owners with income that do not allow Roth IRA contributions.

Spousal IRA: With this account spouses who do not have a steady income flow or do not work at all can still contribute to an IRA based on their working spouse’s income.

Inherited IRAs: This type of IRAs come about when an owner dies and the investment or contributions gets transferred to the deceased beneficiary. Specific rules apply and failure to comply would attract an unplanned bog tax bill for the beneficiary. 

 Self-directed IRA: This type of IRA is a regular IRA only with a slight difference are the investments owned in the account.

Opening an IRA

IRA service providers are mostly financial institutions or financial service providers which includes brokerage firms, mutual funds, or banks. An IRA can either be opened online or in person. There are lots of IRA financial service providers that differ according to the quality of service they provide or individual terms and conditions. The individual differences also influence the types of investments you’d have access to. When opening an IRA with a broker or any other legal IRA service provider an IRA disclosure statement and an IRA adoption agreement and plan document must be issued to the IRA owner as both documents provide and explain foundational IRA rules and regulations. They also serve as guidelines for the owner to follow duly. 

Opening an IRA with a broker gives you access to other investments such as stocks, bonds, and other assets while opening an IRA with a local bank gives you access to Certificates of Deposit and savings account. For new investors looking to invest in the IRA, it is best to get useful IRA educational materials like to have a basic understanding of how it works and what to expect. Also, if you the type of investor who likes to make a lot of trades it would be in your best interest to choose an IRA service provider with lower trading costs. On the other hand, some providers would charge you an inactivity fee if your account is left inactive for 90 days.

The opening process of IRA is quite similar between the providers. The basic requirements include filling your details (general information, social security number, contact information, and useful employment details) in an online registration form.

Tips for opening an IRA 

After getting basic education on how IRAs work and carrying out a research on the best IRA service providers to choose from, the next point of focus should be determining your involvement in the management of your account or investments. Either full involvement or partial involvement.

#1. For full involvement and personal management of investments, an online broker is a better option.

#2. For partial involvement—that is you would like some help in managing your retirement account or investments—a Robo-advisor would be a better option. Robo-advisors not only help you manage your account but also, provides necessary financial advice by selecting low-cost and low-risk investments for you.

Some IRA providers to check out in 2020

Vanguard: This provider offers no monthly fee, but has fees attached to each trade which is bound to increase after multiple trades. The importance of doing so is to discourage contributors to develop a habit of draining their retirement accounts dry. It also encourages investment growth.

Robinhood: This provider is only accessible on its mobile app, however, it still ranks as one of the best online brokerages. It does not have account minimums and trade fees. It also serves as a good entry point for novice investors.  

E-Trade: This provider also offers no account minimum and trade fees, but it offers a promotion of cash credit with a qualifying deposit of $100 to $25,000.

Wealthfront: A Robo-advisor IRA service provider which offers a management fee of 0.25% with a minimum account opening of $500. It also offers a $5,000 promotion on the number of assets managed for free. 

Betterment: Another Robo-advisor provider that offers a 0.25% management fee and $0 account minimum. It currently has a promotion of up to 1 year of free management with a qualifying deposit. 

Key points

• IRAs can be created by any individual with a steady flow of taxable income

• Traditional IRA can reduce a holder’s tax bill yearly contributions if the holder qualifies for a tax deduction, but all taxes would still be paid when distribution occurs in retirement. While Roth IRA contributions are non-tax-deductible, however, this type of IRA allows holder’s investments to grow tax-free and distributions during retirement are also tax-free. SEP and SIMPLE IRAs are directed at employers, self-employed, or business owners. They are similar to a traditional IRA but differ in the income rates.

• General IRA rules permit holders to withdraw money at any time, unless in a traditional IRA where a 10% penalty and tax bill are charged if a holder makes an early withdrawal before age 59 ½, though there are some exceptions.

•  Many financial service providers offer IRA services—brokerages and commercial banks. Each service provider differs in the terms of the quality or type of services they offer, and the type of investment they allow investors.