Chances are that you’ve probably heard of an IRA but for some reason may be unsure about how one works.
The plain and simple truth is that an IRA is actually a pretty simple and useful investment tool. Similar to a 401k there is quite a bit you can do with one to help you save for retirement and reach your financial goals.
But before you can do that, there are a few simple basics you should understand. Not everyone is eligible and in some cases you might be better off concentrating on your other retirement savings tools. Here are the main points that will answer “how does an IRA work” and get you prepared to decide if one is right for you.
What is an IRA?
An IRA is an American retirement plan where an individual sets up an investment account that receives special preferential tax treatment. According to the IRS the term IRA stands for “Individual Retirement Arrangement“. However most people commonly think of it as “Individual Retirement Account”.
Similar to a 401k account, an IRA gives you the option to save your money before taxes get taken out or enjoy tax-free income once you finally retire. No matter which one you choose, this special tax treatment puts more money in your pocket!
Unlike a 401k, you do not need to go through your employer to setup an IRA. You can open one whenever and wherever you choose. The only stipulation is that you have to earn taxable income.
Where Do I Get an IRA?
You can get an IRA from just about any financial services broker, bank, or credit union. The process of signing up for one is very quick and painless; it’s very similar to opening a new bank account either in person or over the Internet.
Most financial service providers will not require a huge initial deposit get your IRA started. Usually a small deposit of $1,000 or so will be enough to open the account.
IRA’s can be just about any kind of typical investment such as stocks, bonds, mutual funds, cash, and ETF’s. Depending on the service provider some will allow you more exotic investments such as precious metals and real estate.
So How Does an IRA Work Exactly?
The main thing you have to know about an IRA before you open one is which kind you’d like to have. For most people this will be one of two basic types:
A Traditional IRA:
The way a traditional IRA works is like this:
- Each year you transfer money from your checking or savings account into your IRA account. As of 2015 the maximum annual limit is $5,500 if you’re younger than 50 and $6,500 if you’re 50 and older.
- At the end of the year when you file your income tax return, your taxable income is reduced by the amount you’ve contributed to your IRA. In other words, the money you contributed is tax deductible and you do not owe on it.
- Your investments grow tax-free as long as they remain in the IRA.
- Someday when you finally retire you pay ordinary income taxes on the money you take out for living expenses each year.
A traditional IRA works great for anyone who thinks they might be in a lower taxable income bracket when they retire.
While you are always allowed to participate in a traditional IRA, you may not be allowed to deduct it from your taxes. This will depend on:
1) Whether or not your employer offers a retirement plan.
2) What your adjusted gross income (AGI) is.
You can find the complete rules for IRA tax deduction here. As you might guess this restriction helps encourage people to participate in their company sponsored retirement plan.
A Roth IRA:
A Roth IRA works the opposite way that a traditional IRA does:
- You again transfer money from your checking or savings account into your IRA account. The annual contributions limits are the same as a traditional IRA ($5,500 if you’re under 50 and $6,500 if you’re 50 or older).
- When you file your tax return, your Roth IRA contributions do not count as a tax deduction. You pay taxes on the earned income that you decided to invest.
- Again your investments grow tax-free.
- When you finally retire the money you withdraw for living expenses.
A Roth IRA is better suited for someone who is in a lower tax bracket now and plans to be in a higher tax bracket in the future.
Your AGI will determine whether or not you’re allowed to participate in a Roth IRA. You can check the latest income limits here.
You Can Combine Accounts:
The $5,500 contribution limit is the maximum amount you’re allowed to save in any combination of the two accounts. For example you could:
- Save $5,500 in a Traditional and $0 in a Roth
- Save $0 in a Traditional and $5,500 in a Roth
- Save $2,000 in a Traditional and $3,500 in a Roth
If you’re married and your spouse earns an income, then both of you are allowed to fund your own IRA accounts (effectively $11,000 per year). Again certain restrictions may apply if your employers offer retirement plans and your AGI is above a certain threshold.
How Do You Get Your Money Back From an IRA?
Similar to a 401k, IRS regulations require the money to stay in an IRA account until you turn 59-1/2 years old. At that point, you can begin taking distributions from your accounts. If you try to do so before then, you’ll be faced with taxes and a hefty 10 percent penalty on the amount you’ve withdrawn. The only exceptions are if you qualify for hardship conditions.
With a traditional IRA you are not required to start taking distributions until you reach the age of 70-1/2. At that point, if you do not withdraw your money at specific intervals, you will incur fines and penalties. With a Roth IRA you will not have this issue because you have technically already paid your taxes on the money.
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