What is an IRA?
Planning and saving for retirement can be challenging for many Americans. It may be hard to put money aside every month when you don’t plan on retiring for another 10 years or more. But it’s never too early, or too late, to start saving for retirement. Most of us plan to stop working someday, but you need to make sure you have enough money saved for your golden years, so you can enjoy your retirement without worrying about money. The sooner you start investing in your future, the more money you will have when you decide to stop working.
There are several ways to start saving for retirement, including opening what’s known as an individual retirement account (IRA). This financial product is a particular type of account that helps you put money aside for retirement while helping you pay as little as possible in income taxes. This money will grow over time with interest to help you make the most of every dollar you earn.
An IRA is similar to an employer-sponsored 401(k) retirement plan. Both types of accounts are designed to encourage workers to save for retirement, but you don’t need a full-time job to open an IRA. Anyone with earned income can open one of these accounts and start saving for retirement. Learn more about IRAs, how they work, and how they can help you prepare for the future.
How Does an IRA Work?
An IRA is an individual retirement account that lets you put money aside for retirement every year. The account is designed to incentivize long-term savings. You will realize certain tax benefits by keeping your money in this account until you reach retirement age. For example, if you deposit $5,000 into a traditional IRA, you can deduct that amount from your income taxes for that year.
There is a limit to how much you can contribute to your IRA. As of 2022, those under the age of 50 can only contribute $6,000 a year, while those over 50 can contribute up to $7,000 a year. These limitations allow older individuals to catch up on their retirement savings.
It all depends on how you plan on managing your money. Different types of IRAs give you access to certain types of investment options that can help you grow your money over the years, such as stocks, bonds, exchange-traded funds (EFTs), as well as real estate and commodities. Each type of account comes with different tax incentives and benefits.
You can also open more than one IRA or more than one type, but your total contributions cannot exceed $6,000 per year or $7,000 per year if you are over 50. The contribution threshold varies based on your income level. The more money you make, the less you can contribute to your account. The money in your account is meant for retirement. If you withdraw the money before you reach the age of retirement, which is defined as 59 1/2, you will pay a tax penalty of 10%
You can open an IRA at virtually any financial institution, such as a bank or credit union. Talk to a lender near you to learn more about the options available in your area.
Who Can Contribute to an IRA?
Anyone can open and contribute to an IRA using earned income from a job or commission. You cannot contribute dividends from stocks and other holdings, Social Security benefits, or child support.
IRAs are common among self-employed individuals who don’t have access to a traditional 401(k). Still, you can open an IRA in addition to your employer-sponsored account to save even more money for retirement.
Benefits of an IRA
There are many reasons to open an IRA regardless of how close you are to retiring. Saving money in today’s economy can be hard enough as it is. But opening an IRA can help. These accounts come with the following benefits:
IRAs are set up to encourage saving. You will face a penalty if you withdraw these funds before you reach the age of retirement, so you’re not tempted to spend this money prematurely. However, there are some notable exceptions to the 10% tax penalty. If you use this money to buy your first home or need to pay for your education, you may not have to pay the penalty.
You can reap tax benefits by depositing a percentage of your earnings into the account every year. Depending on what type of account you choose, you can either deduct your contributions from your income when filing taxes for that year or pay income taxes ahead of time, so you can withdraw that money tax-free when you retire.
Additional Investment Options
Opening an IRA can also help you grow your money over the years. A traditional IRA will grow at a set interest rate, so the sooner you start investing, the more money you stand to make over time. If you use your IRA funds to invest in the stock market or real estate, you can stand to earn even more. However, IRAs limit what kinds of investments you can make. High-risk investments are generally not allowed.
Different Types of IRAs
With a traditional IRA, you can deduct your annual contributions from your income taxes to lower your tax bill come April. When you reach the age of retirement, you will have to pay taxes on these funds just like regular income.
The contribution limit is set at $6,000 per year for those under 50 and $7,000 for those over 50. If you make more than $68,000 a year and file as single, you can only make a partial deduction.
Traditional IRAs also come with required minimum disbursements (RMDs) that require you to withdraw a certain amount of money each year. Your age and life expectancy set RMDs. They take effect once you reach the age of 72, so there’s a good chance you will need to spend your money by then. Failure to withdraw the required amount may result in a 50% tax penalty.
With a Roth IRA, you cannot deduct your contributions from your income taxes, but you can withdraw this money tax-free when you reach the age of retirement. Roth IRAs don’t come with RMDs, so you don’t have to withdraw this money in retirement unless you need it.
Roth IRAs have the same contribution limits as traditional IRAs, but they come with fewer income restrictions. You can make a full deduction if you make less than $125,000 a year. The deduction begins to phase out from there.
A simplified employee pension (SEP) IRA is for self-employed individuals, contractors, and freelancers. They use the same tax benefit system as traditional IRAs, which means you can deduct your contributions from your income taxes for that year.
However, they come with different income limitations. For 2022, SEP IRA contributions are limited to 25% of compensation or $61,000, whichever is less.
Savings incentive match plans for employees, or SIMPLE, IRAs are designed for small business owners and self-employed individuals. They follow the same tax rules as traditional IRAs. Like 401(k)s, employees can deduct their contributions from their income taxes, and their employer must match their contributions. Both are tax-deductible for businesses in the lowest tax bracket. It’s a great way to encourage employees at small companies to save for retirement.
For 2022, the SIMPLE IRA employee contribution limit is $14,000 for those under 50 and $17,000 for those over 50.
The Bottom Line
It’s almost always in everyone’s best interest to have a retirement savings plan. You will likely need more than just Social Security once you reach a certain age and can no longer work. Inflation will also increase the cost of living in the years to come, so consider making the total contribution every year. Putting your money in an IRA will help you earn more over time than a regular savings account. Talk to a financial advisor to find the right type of IRA for your lifestyle.