IRA stands for Individual Retirement Account. There are different types of IRAs based on employment status, income, and taxes.
What’s an Individual Retirement Account (IRA)?
An Individual Retirement Account (IRA) is an account that you can set up at a financial institution to save for retirement. The money that you save can grow tax-free or tax-deferred depending on the type of IRA.
Investments that you hold in an IRA can include stocks, bonds, mutual funds, exchange-traded funds (ETF), certificate of deposits (CD), and savings accounts.
When you have an IRA CD or savings account, it’s less risky because it isn’t being invested in the stock market. However, that also means that the interest rates will be lower.
When you invest in the stock market, you may have greater returns. However, there’s more risk, as it’s being held in the stock market.
According to Fidelity, if you have 10 or more years until you retire, investing in the stock market is an excellent choice because you’ll be able to endure market volatility.
As long as you continue to contribute to your IRA each year, you’ll have long-term growth potential.
Types of IRAs
There are different types of IRAs available. The one you choose depends on different factors, such as employment status, income, and age.
The following are the types of IRAs and why you’d open one over the other:
1. Traditional IRA. The most attractive features of a Traditional IRA are that the money you contribute, and its earnings will grow tax-deferred.
It also doesn’t have an income limit to have it. Regardless of how much you make, you’ll always be able to contribute towards your Traditional IRA.
After you turn 72 years old, you’re required to start taking withdrawals from the IRA, which is called a required minimum distribution (RMD). You can take more than the minimum required amount, and since it’s tax-deferred, it’ll be included in your taxable income (Source: Internal Revenue Service).
Another benefit of opening a Traditional IRA is that it may be tax-deductible. If you have a retirement plan at work in addition to the IRA, the deduction may be limited. If you don’t have a retirement plan at work, the deduction may be allowed in full.
Note: Be sure to check with a financial advisor or CPA to see if it’s deductible for your situation.
2. Roth IRA. If you open a Roth IRA, the contributions are pre-taxed, which means the earnings and future withdrawals won’t be taxed.
Another benefit of the Roth IRA is that you’re not required to take a minimum distribution, and you can leave any amount in it for as long as you’d like.
Unfortunately, you can’t deduct contributions that you make to your Roth IRA, and there’s an income limit. The income limit is based on your adjusted gross income (AGI) and will depend on the year. For the most up-to-date income limit information, view the IRS Roth IRA Contribution Chart.
3. Spousal IRA. If you file a joint return and your taxable compensation is less than that of your spouse, or you aren’t working, you may be able to qualify for a Spousal IRA.
The Spousal IRA can be Roth or Traditional, and it’ll be set up under one person’s name, so it won’t be a joint account.
If you’re the one that is opening the Spousal IRA, your spouse can contribute the maximum IRA contribution that’s allowed into the account.
4. SEP IRA. If you’re a business owner, you can offer your employees a retirement plan by opening a Simplified Employee Pension (SEP) IRA. It’s also an option for you if you’re self-employed or a freelancer.
The benefit of opening a SEP IRA is that it doesn’t have the start-up and operating costs of a traditional retirement plan.
It also allows you to contribute up to 25% of your employee’s pay, but it can’t exceed a certain amount that’s set by the IRS. For 2020, the maximum is $57,000 (Source: IRS).
For this type of IRA plan, only the employer can make contributions, and all eligible employees must receive equal contributions.
5. SIMPLE IRA. SIMPLE is an acronym for Savings Incentive Match Plan for Employees. It allows employees and employers to contribute to a Traditional IRA that’s set up for the employee.
It’s designed for small businesses that are getting started and aren’t sponsoring a retirement plan.
The employer is required to contribute each year, which can be matching up to 3% of an employee’s compensation or 2% non-elective contribution for each eligible employee.
For a non-elective contribution, the employer is required to contribute 2% of the employee’s contribution, even if the employee didn’t contribute to their SIMPLE IRA.
6. Inherited IRA. When the original owner of an IRA passes away, the beneficiary will inherit the IRA. This is called an Inherited IRA, or Beneficiary IRA.
If the IRA is inherited from a spouse, the surviving spouse can designate themselves as the new account owner, roll it over, or be treated as a beneficiary rather than making it their own.
If it’s inherited from someone other than a spouse, the beneficiary cannot be the new account owner.
This means that the beneficiary can’t make contributions, or do a rollover in or out of the Inherited IRA. The beneficiary will have to pay taxes when the funds are withdrawn if it’s a Traditional IRA.
For more information regarding contribution limits and taxes, read IRS Contribution Limits.
Understanding the rollover
If you have multiple retirement plans and want to consolidate them into one, you can do a rollover. A rollover is a tax-free way to move money from one retirement account to another (Source: Investor.gov)
A rollover doesn’t have to be from an IRA. It can also be from an employer-sponsored plan, such as a 401(k) or 403(b).
Another benefit of doing a rollover is that it allows you to move funds without paying taxes or getting penalized for an early withdrawal.
Take the following steps to rollover your IRA or employer-sponsored plan:
- Open a Rollover IRA.
- Provide all of the account information to fund your new account.
- Invest your funds.
All of the work will be done by the financial institution, so it’s straightforward from your end.
Frequently asked questions
What’s the difference between an IRA and 401(k)?
IRAs and 401(k)’s are both retirement accounts. The only difference is that a 401(k) is an employer-sponsored plan, which means you get it through your employer.
At what age should you open an IRA?
Once you turn 18, you should open an IRA and begin saving for retirement because you’ll have time on your side.
Can you lose money in an IRA?
Since the IRA is a shell, it depends on how you invest the funds. If you invest it in the stock market, there’s always market risk, which means you can lose money. On the flip side, you can invest in an IRA CD or savings account, which is a regular deposit account that’s federally insured.
An IRA is an excellent way to save for retirement. Since there are contribution limits, it’s a good idea to diversify your portfolio by having other investments, savings, and retirement plans.
The IRA itself isn’t an investment, it’s more of a shell. You’ll have to decide or work with a financial advisor to figure out what the best ways are for you to grow your IRA account.
Featured image courtesy of Unsplash.
About David Em
David Em is the founder of More Money More Choices, which he launched to help you take control of your finances and build your dream life. Before More Money More Choices, David worked in leadership positions in the finance industry.