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Individual Retirement Accounts

Individual Retirement Accounts (IRAs) are tax-advantaged savings accounts designed to help individuals save for retirement and are offered in the United States.

Anyone with earned income is welcome to set up an IRA with the limitation on the total amount of annual contributions. Earned income means you’ve worked for it. Income through investments, Social Security, or child support is not earned, therefore not eligible for IRAs.

There are several types of IRAs, but the two most common ones are Traditional IRAs and Roth IRAs.

Traditional IRA

Contributions to a Traditional IRA may be tax-deductible, depending on your income and whether you have access to a retirement plan through your employer. If you’re eligible for the deduction, it can lower your taxable income for the year in which you contribute. Imagine you make $50,000 in year X and put $5,000 into your traditional IRA, your taxable income would come down to $45,000. Traditional IRAs do not have income limits, meaning that you can contribute to your IRA regardless of how much you make. This is not the same for Roth IRAs. However, annual contributions may not exceed $6,500 or $7,500 if you’re older than 50. Be aware of possible changes regarding those rules.

Withdrawing funds from a Traditional IRA before age 59½ will generally come with an early withdrawal penalty of 10% of the amount withdrawn. This penalty is in addition to any regular income tax owed on the distribution.

Possible exceptions include but are not limited to: First-time home purchase | Qualified higher education expenses | Disability | Substantially Equal Periodic Payments (SEPP) | Medical expenses | IRS Levy

Please consult with an expert if you are eligible to avoid the penalty-tax. Visit the IRS website for more information. Be aware of possible changes regarding those rules.

When you reach age 72 (or 73 when you turn 72 after December 31, 2022), you must begin taking RMDs from your Traditional IRA. These withdrawals are subject to income tax. Be aware of possible changes regarding those rules.

Investments within a Traditional IRA grow tax-deferred, meaning you won’t pay taxes on the earnings until you withdraw the funds during retirement. Those withdrawals will be taxed at your ordinary income tax rate. 

Roth IRA

Contributions are made with after-tax dollars, so they are not tax-deductible. In other words, if you make $50,000 and decide to put money into your Roth IRA, you’re taxable income will still be $50,000. But, that also means that qualified withdrawals, including earnings, are tax-free in retirementAnnual contributions may not exceed $6,500 or $7,500 if you’re older than 50. If you’re single and make more than $138k a year, you’re not eligible to set up a Roth IRA. More numbers can be found hereBe aware of possible changes regarding those rules. 

Withdrawing funds from a Roth IRA before age 59½, will generally come with an early withdrawal penalty of 10% of the amount withdrawn. This penalty is in addition to any regular income tax owed on the distribution. However, if you want to take out the money that you’ve contributed (not the earnings), you may take those contributions out of the account at any time without facing a penalty.

Possible exceptions include but are not limited to: First-time home purchase | Qualified higher education expenses | Disability | Substantially Equal Periodic Payments (SEPP) | Medical expenses | IRS Levy

Please consult with an expert if you are eligible to avoid the penalty-tax. Visit the IRS website for more information. Be aware of possible changes regarding those rules. Be aware of possible changes regarding those rules.

Roth IRAs do not require you to take RMDs during your lifetime, which can provide more flexibility in retirement planning. In other words, you don’t have to take out the money if you don’t want to.

Earnings are tax-free, meaning everything you have contributed to your Roth IRA will be tax-free after the age of 59½. There is a five-year rule on Roth IRAs. If you open your IRA at age 58 and think you can get all your contributions including earnings back at 59½ without facing penalties, take a step back. You have to have the account for at least five years. Once you reach the penalty-free withdrawal age and met the five-year rule, you can withdraw the entire account without paying any taxes.

You may be able to convert a Roth IRA into a Traditional IRA and vice versa. It’s important to note that there are contribution limits and income restrictions for both Traditional and Roth IRAs, and these limits may change over time due to tax laws and regulations. A good resource for those numbers would be the Internal Revenue Service website (irs.gov).

How are those different from 401k plans?

Individual Retirement Accounts (IRAs) and 401(k) plans are both retirement savings vehicles in the United States, but they have key differences in terms of eligibility, contribution limits, employer involvement, and investment choices.

  • IRAs are typically opened by individuals through financial institutions or brokerage firms. 401k plans are only available to employees of companies that offer them.
  • IRAs offer a wide range of investment options, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and other financial instruments. Those are typically determined by the financial institution where the IRA is held. Investment options within a 401(k) plan are selected by the employer and are usually limited to a set menu of investment funds.
  • 401k plans have higher contribution limits.
  • Contributions to an IRA are immediately vested, meaning the account holder owns all the money in the account from day one.Employer contributions to a 401k plans may be subject to a vesting schedule. 

IRAs are a valuable tool for retirement planning, and individuals should carefully consider their financial situation and retirement goals when choosing between Traditional and Roth IRAs or deciding to open other types of retirement accounts. Please consult with a financial advisor or tax professional for personalized guidance on retirement planning. 

Disclaimer: This content is for informational purposes only and is not intended as financial advice. We try to provide accurate information on personal finance and investing, but it may not apply directly to your individual situation. We are not financial advisors and we recommend you consult with a financial professional before making any serious financial decisions. There are risks associated with any investment which include but are not limited to stocks, bonds, currencies, cryptocurrencies, as well as any other market or investment vehicle. For more Terms, click here.