what is an ira and how can you use it
Investing | Retirement Planning

What Is an IRA and How Can You Use It?

An Individual Retirement Account or IRA, as it’s known in the financial world, is an account designed to help with your savings and retirement.

The account holds various investments, and many people choose this retirement plan because they offer tax advantages. Most financial advisors would say IRAs are something everyone needs.

We tend to agree.

In this article, we’ll cover everything you need to know about IRAs and why it’s seldom too late to set one up.

How do IRAs work?

IRAs are not an actual investment themselves. They are retirement plan that is used to hold your assets. So, you can choose the investments you prefer, whether it is stocks, bonds, ETFs (exchange-traded funds), or mutual funds.

You can only set up an IRA with a financial institution approved by the IRS, whether it is a bank, brokerage firm, savings, loans association, or a federally-insured credit union. Your IRA contribution amount is based on earned income that aligns with IRA rules.

There are also potential penalties for withdrawing money too early. The eligible contributions also change year to year and depend on the type of IRA you choose.

Can anyone set up an IRA?

Yes. However, the type of IRA you set up is based on the following: 

Individual taxpayer

If you are traditionally employed, you can establish:

  • Traditional IRA: Most people open a traditional IRA because contributions are tax-deductible. So if you contribute $5,000 to your IRA, your income that year is reduced by $5,000. This doesn’t mean you get off scot-free, however. Your withdrawals are taxed based on your usual tax rate. The IRA contribution limit for most people is no more than $6,000 per year. If you are over 50, you can do up to $7,000 using what’s called catch-up contributions.
  • Roth IRA: A Roth IRA does not have tax-deductible contributions. Instead, they offer qualified tax-free distributions. While this doesn’t sound so great, the benefit is that you aren’t taxed on your investment gains when you contribute to a Roth IRA using after-tax dollars. AND when you make withdrawals during retirement, you also aren’t taxed. In fact, the tax-free withdrawal benefit is what draws most people to a Roth IRA.

Small business owners or self employed

If you own your own business or are self-employed, you have two options:

  • SEP IRA: The simplified employee pension is similar to traditional IRAs. The same taxes are applied for withdrawals. You can receive a tax deduction for contributions made to a SEP-IRA for small business owners and any contributions to any eligible employee’s plans.
  • SIMPLE IRA: The “savings incentive match plan for employees” IRA follows the same tax rules for withdrawals as a traditional IRA. However, in this case, it works by employees making contributions that must be matched by their employer. It benefits both the business owner and employee because the contributions are tax-deductible.

Each type of IRA comes with its own set of rules and regulations. However, for all IRAs, you must make your IRA contributions for the prior tax year on or before the April 15 tax filing deadline.

Types of IRAs

Here is an overview of rules for each of the types of IRAs:

Traditional IRA

Deduction modified adjusted gross income (MAGI) limits for retirement plans at work:

  • Single or head of household: $66,000 or less with a full tax deduction of your contribution OR more than $66,000 but under $76,000 with a partial deduction OR $76,000 or more and no deduction
  • Married filing jointly: $105,000 or less for a full deduction up to your contribution level OR more than $105,000 but less than $125,00 for a partial deduction OR $125,000 or more for no deduction
  • Married filing separately: Less than $10,000 for a partial deduction OR $10,000 or more for no deduction

Your traditional IRA requires you to start taking the required minimum distributions (RMDs) at the age of 72. These RMDs are based on the size of your account and life expectancy. If you don’t, you can face penalties equal to 50% of whatever your required distribution amount is.

Roth IRA

There are no differences between Roth IRA and traditional IRA contribution limits. However, there are modified adjusted gross income (MAGI) limits for contributions as follows:

  • Single or head of household: Less than $125,000 have contributions up to the limit OR $125,000 to less than $140,00 with a reduced amount of contributions OR $140,000 or more with zero contributions
  • Married filing jointly or a qualifying widow: Less than $198,00 up to the limit, OR $198,000 to less than $208,000 at a reduced amount, OR $208,000 or more at zero.
  • Married filing separately: Less than $10,000 at a reduced amount OR $10,000 or more at zero.

SEP IRA

SEP IRA contributions are limited to which is less: either $58,000 or 25% of compensation. Suppose you set up a SEP IRA for your employees in the case of business owners. In that case, you can deduct any contributions you make for them. But your employees can’t contribute to their own accounts.

SIMPLE IRA

Employee contributions for SIMPLE IRAs are limited to $13,500, with a catch-up limit for those over 50 of $3,000.

What are the tax implications for a traditional IRA and Roth IRA?

When you contribute to a traditional IRA, your contributions are made “pre-tax”. As a result, the money you contribute is not taxed the year you make your contribution.

The benefit of this option is you reduce your taxable income. The downside is that you are deferring the taxes, which must be paid when you withdraw the money when you reach retirement age.

For a Roth IRA, it is the opposite, providing an “after-tax” account. In this case, you make contributions after you have already paid your taxes.

So while you see no benefits at tax time, you do see the benefit when you retire (withdrawals are tax-free). You get the total amount of your contribution when you start withdrawing from your account.

What are catch up contributions?

A catch-up contribution only applies to people 50 and over. It allows for additional contributions to a Roth IRA or traditional IRA and 401(k) accounts. The result is the total contribution is larger than the limit. This is good news for people that fall into this age category because it makes it easier to build their retirement savings. You can contribute up to an additional $1,000 to your Roth IRA or traditional IRA and up to $6,500 to your 401(k).

Can I contribute to more than one retirement account?

So the answer here is yes. BUT you have to keep in mind this does not mean you can contribute more. If your plan were to contribute your limits for each separate account, this is not allowed. You can still only contribute the annual limit amount, which you would have to spread amongst your accounts.

A better option might be to make contributions to a traditional IRA or Roth IRA, as well as a 401(k) plan, based on the limitations that apply to your situation.

What are the pros and cons of traditional IRAs and Roth IRAs?

Let’s look at it from the post and pre-tax point of view:

Roth IRA pros

  • Because the taxes are paid on your contributions, you can look forward to the total amount of your nest egg when you retire (tax-free withdrawals).
  • If you have a pretty big nest egg to look forward to, you might prefer this option as you would avoid issues should you face a higher tax bracket at retirement time.
  • Any contributions made after taxes can be withdrawn penalty-free because you’ve already paid your taxes.

Roth IRA cons

  • Any profits in your account can’t be touched until you reach the age of 59.5 years.
  • Your paycheck will be smaller because your contributions are deducted.

Traditional IRA pros

  • You, in essence, have a higher annual income because your contributions reduce the taxes you pay that year.
  • When you open a traditional IRA, you can take a tax deduction in the tax year that you contribute to the traditional IRA
  • Anybody can contribute to a traditional IRA
  • Contributions to a traditional IRA will see tax-deferred growth

Traditional IRA cons

  • Your withdrawals require taxes paid which eats into your profits earned and the money you contributed originally
  • When you make nondeductible (after-tax) contributions, you must report them on your taxes using a special Form 8606
  • When deciding which is best, don’t forget to consider the contribution limits and how they affect your ability to save

What happens to my IRA if I change jobs?

Nothing. IRAs are individual retirement accounts – they aren’t managed by your employer like your 401(k) is. In some rare circumstances, your employer might manage your IRA, but it’s doubtful. So when you change jobs, you don’t really have to do anything with your IRAs.

On the other hand, your 401(k) will remain under the management of your former employer until you determine what to do with it. Most people choose to roll it into their new 401(k) or simply roll it into an IRA (which we recommend).

You will not have to pay any taxes as it is simply moving your money to a new account, so it is not considered a withdrawal.

Can I make early withdrawals to my IRA?

Yes, but you will have to pay the penalty. Since IRAs are designed for retirement savings over the long term, any withdrawals made before your reach 59.5 years of age will ding you with a 10% penalty. You also have to pay deferred taxes on the amount. Here’s what that would look like:

  • Withdrawal: $10,000 from a traditional IRA
  • Your Tax Bracket: 25%
  • Your Penalty: $1,000 penalty
  • Your Deferred Taxes: $2,500 taxes
  • Your Net Withdrawal: $6,500
  • Your Loss: $3,500

So you really need to consider your losses before deciding to make an early withdrawal.

What if I have a financial emergency?

If you have a traditional IRA, there are emergency circumstances in which you would not be penalized. You would still have to pay the deferred taxes as the withdrawal is considered income. But you would not be charged the additional 10% penalty. This is called a “hardship withdrawal” and includes:

  • Unreimbursed medical expenses over 7.5% of adjusted gross income (AGI) or 10% if you are under 65
  • Qualified higher-education expenses
  • Purchasing your first home (up to $10,000)

Also, qualified military reservists called to active duty can make withdrawals for certain circumstances.

What types of investments are allowed for my IRA?

The good thing about IRAs is that they are considered “self-directed.” As a result, you are in the driver’s seat when it comes to choosing your investments. You can choose to invest in mutual funds, bonds, stocks, ETFs, annuities, or cash.

What are annuities?

Annuities provide regular deposits from your IRA. They work well when you want to have a continuous stream of income once you retire. However, because you are getting a regular stream of money from your IRA, the annuity only makes sense for Roth IRAs since you’ve already paid the taxes.

Otherwise, you end up paying taxes on every deposit received. Even if you have a Roth IRA, you should only look at single premium immediate annuities (SPIA). In this case, because you trade a one-time payment to the insurance company for payments for a life plan, it is an excellent way to get more bang for your buck if you exceed your life expectancy.

When it comes to annuities, we advise a buyer beware stance because you are more than likely to face complicated cost structures. You might not realize until it’s too late that you are expected to pay all kinds of fees for your annuity, such as annual fees and surrender fees.

Also, annuities charge market value adjustments and impose their own restrictions when funds are withdrawn. You might even come across restrictions on how you use the funds in the annuity.

Are market value adjustments bad?

They can be. They refer to adjustments made to the amount you can withdraw from your annuity based on the market conditions.

So, for example, if interest rates have gone up, you’ll see a rise in additional fees on top of what is called the stipulated surrender rate.

As a result, you get less of your savings. On the flip side, you can offset your surrender charge in the case interest rates drop, so you actually get more from your withdrawal.

What investments are not allowed for my IRA?

Yes, there are several investments prohibited by the government, including:

  • Collections from art to coins and stamps to antiques
  • Derivative trade
  • Life insurance
  • Real estate either that your rent or live in
  • Most coins
  • Many types of precious metals

However, the list of acceptable investments is far longer, leaving many options open.

Can I leave my IRA to someone in my will?

While this article isn’t about estate planning, we want to make sure we cover an essential estate planning piece when it comes to your retirement accounts.

Yes, you actually are required to name a beneficiary for your Roth or traditional IRA. Anything you have not withdrawn from your IRA would go to your beneficiary.

However, they can only access the money based on the IRA rules, including age-based limitations for early withdrawals. In married couples, the IRA goes to your spouse unless you specifically name another beneficiary. 

Final thoughts

Hopefully, this article gave you a sense of how important an individual retirement account can be. In our opinion, everyone needs either a traditional or Roth IRA, and it should be a priority for your financial future.

You can reap the tax benefits when managed well while also providing financial security for a comfortable retirement in your golden years.

And remember, a Roth IRA will get you tax-free withdrawals at retirement time. At the same time, a traditional IRA will allow you tax deductions in the year you contribute.

Both have pros and cons, and both are good for different audiences. Do what’s best for you, but either way, make sure you start investing.