The Basics About IRAs

Feb 3, 2021Uncategorized

Planning for retirement is one of the most important things people can do to ensure they have financial security later in life. Relying on Social Security is a dangerous prospect as there has been talk of it failing for years now. This means it is more important than ever to take your retirement savings into your own hands.

 

One of the smartest ways to do this is through an IRA. But you may have some questions.

  • What is an IRA?
  • Should you invest in an IRA?
  • How does an IRA benefit me now and later?
  • What is the best IRA for my situation?
  • Where can I get started?

Let’s take a look at these so you can better understand if an IRA is right for your financial future.

 

What is an IRA?

IRA stands for “Individual Retirement Account” and it allows you to save money towards your retirement with certain tax-advantages. There are 3 main types of IRA’s to consider, all with different advantages and particulars.

  • Traditional IRA: here you make contributions (usually monthly) into your retirement account from funds you can deduct off your tax return, and earnings can grow on a tax-deferred basis until you need to withdraw money during your retirement. The benefit here is that when most people retire their income is reduced and they fall into a lower tax bracket than when they were working. The tax-deferred benefit means that when you take the money out you are taxed at your current, in this cased retired, tax bracket which is almost always lower due to less income coming in.
  • Roth IRA: here you make contributions (usually monthly), but these are made after you’ve already paid taxes on them. So your money can grow potentially in a tax-free way, including tax-free withdrawals when you hit retirement age and need to take money out for your living expenses. The difference is you pay tax on the front end.
  • Rollover IRA: These are only available when you are already in an employer-sponsored plan like a 401(k) or 403(b), into an IRA. So you contribute “rollover” money from those qualified retirement plans into the rollover IRA.

You can see there are some clear tax benefits to using an IRA, no matter if you pay taxes upfront or when you take out the money. This is one of the largest incentives for utilizing an IRA for retirement.

 

Should You Invest in an IRA?

Many people incorrectly believe a small portion of their working income will be necessary for retirement. History has shown that retirement is far more expensive than many people expect. Some financial advisers advise you’ll need over 2/3’s of your pre-retirement income to live comfortably after you eventually retire.  It may not be enough to rely on an employer-sponsored 401(k) or you may be self-employed and unable to utilize a 401(k) or 403(b). Luckily, you can put money into an IRA whether you are contributing to a 401(k) or not.

 

An IRA helps with:

  • Tax-advantaged potential growth and income
  • Saving at a higher rate towards your retirement
  • Accessing a larger range of investment asset opportunities
  • Self-directing your retirement finances
  • Keeping more of what you’ve saved when you hit retirement age

IRA’s do have a yearly contribution maximum so it’s always a smart idea to hit that maximum year over year to best save for your retirement. Always monitor your investments if you’re doing it on your own and it’s smart to reduce your risk as you get closer to retirement age. When you’re 30 years old you have a lot more time to make up any losses or market downturns by the time you hit 65. If you’re 60 and the market takes a large downswing that could impact your retirement savings. So always reduce your risk as you get closer to retirement.

 

How Does an IRA Benefit Me Now and Later?

Your contributions make a big difference in the growth of your IRA. The more you put in the greater the level your growth will be however there is a limit of $6,000 if you’re under 50 years old and $6,000 + $1,000 “catch-up contribution” if you’re over 50 years old. The more you put in every single month the greater your growth potential.

 

  • IRA acts as a savings mechanism that will help you during retirement
  • Compounding interest builds over time
  • It helps reduce your tax bill
  • Many investments to choose from
  • Reduced ageist withdrawal limitation (Roth IRA)
  • Improved terms for heirs
  • Nearly anyone can contribute to an IRA
  • Different IRA’s for any situation

There are short-term benefits to using an IRA but most of the benefits will come later in life after you hit retirement age. The point of planning for retirement is being prepared for your later years. An IRA does just that, it builds for your future and that of your family.

 

Compounding Interest

Compound interest is the interest you earn on interest. This can be illustrated using simple math: if you have $1000 and it earns 5% interest each year, you’ll have $1,050 at the end of the first year. At the end of the second year, you’ll have $1,102.50. This increases on top of itself over time with each passing year. This is why the younger you start the more time compounding interest will have to work its magic and build your retirement account on its own.

 

Reduced Ageist Withdrawal Rules

Money in an IRA (traditional) is subject to “required minimum distributions” or RMD. This means you must start withdrawing funds from your IRA at the age of 72. If you fail to do the Internal Revenue Service can punish you with a 50% excise tax penalty on the amount you didn’t take out.

 

However, through a Roth IRA, there is no RMD. This means you don’t have to start withdrawing money at 72 years old or any other age. You can hold that cash until later in life or whenever you need it.

Investors can also avoid selling off assets during a market downturn. A traditional IRA forces you to withdraw (sell) positions to take out cash after 72 years old. If the market goes down, you still have to sell but at a lower price. Therefore, providing you with less income.

 

Also, with a Roth IRA, your investments can continue to grow in a tax-free manner. You aren’t forced to withdraw funds if you don’t need to and this means compounding interest won’t stop or be reduced either. It means you won’t be forced to dip into your IRA unless you really need the money. This is an added level of protection many people will look forwards to.

 

Improved Terms for Your Heirs

Worried about what happens to your IRA when you pass away? Unlike in a traditional IRA or 401(k), a Roth IRA offers advantages to your beneficiaries. With a Roth IRA, the tax-free benefits are inherited, so this is a major advantage to your loved ones after you’ve passed away. They continue to receive the tax benefits of your Roth IRA.

 

Nearly Anyone Can Contribute to an IRA

IRAs can be set up by just about anyone. There are different income levels for different types of IRA’s. There are also yearly contribution limits based on your income as well as federal caps on IRA yearly contributions. If your income is too high and you can’t open a Roth IRA there are a few workarounds. One is that you can convert an existing traditional IRA you have into a Roth IRA.

 

Who is an IRA Ideal For?

In a nutshell, anyone looking to save for their retirement, most especially if they do not have access to a traditional 401(k) through their employer. The type of IRA that is good for you depends on your situation.

  • Traditional IRA (anyone)
  • Roth IRA (anyone)
  • SEP IRA (self-employed/small business owners)
  • SIMPLE IRA (small businesses with less than 100 employees)

As you can see there is an IRA for just about any circumstance so you shouldn’t have a hard time getting one started.

 

Where to Find Your IRA?

Just about every major financial institution has an IRA program and there are loads of smaller online banks and brokerages that offer IRA’s. Have an existing brokerage account somewhere? Maybe you’d like to keep your IRA within a single umbrella. Or maybe you want to look towards some of the new online banks that offer better rates on their IRA’s than large banks. Either way, do some homework and you’ll be ready to start your journey towards retirement security.

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