An Individual Retirement Account, also known as an IRA, could play a big role in your retirement savings plan. IRAs help you save for retirement while also protecting you from the IRS.
It’s a type of savings account that provides some tax benefits, like offering tax-free growth or tax-deferred status.
If you haven’t added an IRA to your retirement savings plan, you could be missing out on a great opportunity to make the most out of your retirement and reduce your taxes.
There are different types of IRAs, each with different tax implications and eligibility requirements. We’ll start with the two most common types of IRAs — traditional IRAs and Roth IRAs.
Read on to find out more about them and which one you should go for.
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Table of Contents
A traditional IRA is a tax-deferred retirement savings vehicle where you set aside money that is separate from your checking account. With a traditional IRA, you won’t have to pay any taxes on your earnings with this account until you decide to withdraw the funds.
Therefore, you may be able to build up more in an IRA compared to taxable accounts because you’re able to defer taxes on interest and dividends earned by your IRA’s investments.
An IRA isn’t an actual investment, but a type of account that may be funded with investments like bonds, CDs, mutual funds, and stocks.
You can contribute to a traditional IRA if you’re under the age of 70 1/2 and you have earned income. Your contribution may be tax deductible if you meet certain criteria.
The restrictions on who can take deductions for traditional IRA contributions are based on your income and if you or your spouse are covered by a retirement plan provided by an employer.
IRAs shouldn’t be accessed before retirement unless there’s a good reason. If you withdraw money before reaching the age of 59 1/2, there’s an additional 10% tax on that early distribution. This penalty tax is in addition to federal and state income taxes at your ordinary income tax rate.
There are some exceptions that allow you to withdraw money from your IRA without penalty if you meet certain criteria, such as medical expenses, health insurance, military service, or college fees and tuition.
When you’re withdrawing money from an IRA, the distribution is taxed as ordinary income and is included in your taxable income.
With a traditional IRA, minimum distributions must be taken out no later than the year when you turn 70 1/2. If you don’t meet the required minimum distribution each year, you’ll have to pay an excise tax consisting of 50% of the required minimum distribution amount.
A Roth IRA is a non-deductible retirement savings vehicle where you also set aside money that is separate from your checking account. Unlike a traditional IRA, a Roth IRA gives you tax-free growth of retirement savings and distributions.
Roth IRA distributions are 100% tax-free as long as you meet certain conditions. Thus, you may be able to build up more in your Roth IRA than in a taxable account because you’re not paying tax each year on interest and dividends earned in your Roth IRA account.
Like traditional IRAs, Roth IRAs aren’t an actual investment and may be funded with bonds, CDs, mutual funds, and stocks.
Even if you’re covered by an employer’s retirement plan, it is possible to make contributions to your Roth IRA. Contributions are determined by your income limitations.
Unlike traditional IRAs, Roth IRAs aren’t subjected to required minimum distribution rules during your lifetime.
Traditional IRAs vs. Roth IRAs
So, which one should you choose? Deciding between a traditional IRA or a Roth IRA can be a tough decision to make.
It ultimately comes down to whether you’re wanting to take advantage of deducting a part of your contributions upfront if you qualify, or enjoy tax-free withdrawals later.
Both of these are good tax-advantaged account options, but if you’re not sure which one is better, then we’ll help you on that.
First, estimate how soon you’ll be needing access to your retirement savings. You must be at least 59 1/2 to begin withdrawing funds from either account without a penalty.
Usually, you’ll have to own a Roth IRA for at least five years before you can access it without being taxed on growth earnings.
However, you can always withdraw your original contributions without a penalty whenever you want. If you believe you may need the money sooner than five years after account opening and you may need to access your original contributions and earnings, the traditional IRA may be better for you.
If you have a long-term time frame over five years, you shouldn’t have to worry about this.
Second, find out how much of your contribution you can potentially deduct. If you earn too much to make a tax-deductible contribution to a traditional IRA, but you still need to qualify for a Roth IRA, choose a Roth IRA.
If you earn too much to contribute to a Roth IRA, you can still use Roth IRA conversion rules to make a Backdoor Roth IRA contribution which allows you to get around income limits by converting a traditional IRA into a Roth IRA.
Lastly, look over the estimated taxable income level you plan on being at during retirement. If you believe you’ll be in a high tax bracket, the tax-free distribution of a Roth IRA may be the choice for you.
If you can’t deduct your traditional IRA contributions or set aside money for a Roth IRA, you can opt for a non-deductible IRA. Similar to a Roth IRA, you don’t get deduction for your contributions to a non-deductible IRA. However, distributions are taxed differently.
Though non-deductible IRA contributions won’t reduce your taxes during the year you make them, the earnings on them are tax-deferred which is an advantage for a regular IRA.
When you’re taking tax distributions from a non-deductible IRA, part of the distribution will be a tax-free return of your original, non-deductible contribution, and the remaining amount will be taxed as general income.
What distinguishes a non-deductible IRA from a traditional IRA is the treatment of the tax of the original contribution. Nonetheless, most of the other rules that apply to traditional IRAs also apply to non-deductible IRAs.
Non-deductible IRAs are best for people who are already in an employer’s retirement plan and either they’re ineligible to contribute to a deductible traditional IRA or their income is above the Roth IRA eligibility threshold.
The best thing about a non-deductible IRA is the ability to save more for retirement in an account that has tax-deferred growth of earnings.
IRA Contribution Limits & Deadlines
The total amount that can be contributed to a traditional IRA and/or a Roth IRA is limited. For example, the maximum annual contribution for 2017 was either $5,500 or 100% of earned income, whichever was lesser. If a taxpayer is over 50 year of age, they can contribute another $1,000 for a total contribution of $6,500.
Both types of accounts can be contributed to as long as you don’t exceed the annual contribution limits.
For instance, you could put $3,000 in a traditional IRA and $2,000 in a Roth IRA, or any other amount, as long as you don’t exceed the annual limit of $5,500.
Your qualifying income, such as alimony, wages, self-employment income, and non-taxable combat pay, also limits IRA contributions.
Thus, if you have $4,000 in earned income, that will be your contribution limit. This is important for parents who are looking to make IRA contributions for their children who may have limited income from working part-time.
In addition, if you earn too much, you won’t be able to contribute to a Roth IRA or take a deduction for contributions to a traditional IRA.
Your IRA contributions can be made any time throughout the year. They aren’t limited by the calendar year, but they must be made by tax day to count toward your contribution limit for the year before.
For example, you can make a 2018 IRA contribution until April 15, 2019.
Opening, Funding, & Investing an IRA
Once you believe that an IRA is best for you, you’ll need a place to open an account. If you’re interested, HMB provides a list of the best brokerage bonuses you can opt for to find the best brokers and other account providers for you, plus you’ll be able to earn a bonus when you open an account.
But generally, you can open an IRA through most large financial institutions, banks, mutual fund companies, or brokerage firms.
You’ll want to find an IRA account provider that has no account fees or offers very low fees, offers a good selection of mutual funds with no transaction fee and commission-free exchange traded funds, gives high-quality customer service and access to unbiased financial education resources (these are great if you’re new to investing), and has low account minimums and fund minimums.
When you’re funding your IRA, make sure you go through your IRA provider’s account set up process because not every one will be the same. Some IRA providers offer online account registration to make it easier for you.
Essentially, you’ll be establishing the method of funding your account, such as through check, electronic transfers from your bank account, and rollovers, and naming beneficiaries for your account.
If you’re not sure how you should invest money into an IRA, IRAs offer a variety of different options. For instance, you can do annuities, bonds, individual stocks, mutual funds, exchange-traded funds, and certain types of real estate holdings.
The type of investments and overall amount of asset you can put into each IRA depends on your risk tolerance and amount of time you have.
You can select an all-in-one investment fund, like a target date retirement fund, that can take care of where your asset goes for you or customize your portfolio if you’d like.
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Funding for your retirement should be easier for you now that you know how to choose between a traditional IRA and a Roth IRA. You can earn tax benefits and make the most out of your retirement savings plan.
However, make sure you take a look at all the available options for you before you jump onto the bandwagon. You can check out our available best brokerage bonuses to learn more about investment options.