Everything you need to know about IRAs
What is an IRA, exactly? A closer look at what you need to know before opening an individual retirement account.
Individual retirement accounts, better known as IRAs, are some of the best ways to save for retirement. They’re different from a 401(k) in that you can participate in a 401(k) if you have an employer who offers one, but almost anyone with earned income can open an IRA. There are several different kinds of IRAs, each with its own requirements and features, but all offer important tax advantages.
The most popular types of IRAs are traditional IRAs and Roth IRAs. For each, the maximum yearly contribution is $5,500 through 2017—or $6,500 if you’re 50 or older. Here’s what you need to know about each type of IRA.
Traditional IRAs provide tax-deferred growth. This means your money grows tax-free until you begin taking distributions, at which point your withdrawals are taxed at your income tax rate. What’s more, contributions are often tax-deductible. For instance, if you make $40,000 per year and put $3,000 in a traditional IRA, you pay income tax on only $37,000.
For 2016, if you (or your spouse, if you had one) were covered by a workplace retirement plan, your contributions are at least partially deductible if your modified adjusted gross income is less than $71,000 if you’re single or $118,000 if you’re married filing jointly. For 2017, those numbers rise to $72,000 and $119,000 respectively. If you and your spouse don’t have access to a company-sponsored plan, your contributions are deductible no matter what your income is.
A traditional IRA can be useful for those who have maxed out their 401(k) and want to save more, for those who don’t qualify for a Roth IRA (see next section), and for those who anticipate being in a lower tax bracket after retirement. IRAs may offer more investment flexibility than many 401(k)s. Anyone with earned income who will not reach age 70½ by the end of the year is eligible to open a traditional IRA. If you withdraw funds from your traditional IRA before age 59½, however, you have to pay income tax and an additional 10 percent tax on your withdrawal—though some exceptions do apply.
Contributions to Roth IRAs aren’t tax-deductible, which means you pay more in income taxes up front than you would with a deductible contribution to a traditional IRA. The trade-off is when you withdraw your contributions, you get to take home the full amount federal tax-free (as long as the Roth IRA has been open at least five years and you’re older than 59½). In addition, unlike deductible contributions to traditional IRAs, contributions to a Roth IRA can be withdrawn at any time, tax- and penalty-free.
Roth IRAs are attractive accounts for those who can afford to pay taxes now for the reward of tax-free income later. Two other features that set the Roth apart from the traditional IRA: There is no age limit to open a Roth IRA and no required minimum distributions once you reach age 70½. However, to contribute in 2016, you must have earned income, and single tax filers must make less than $132,000 per year, while joint tax filers must make less than $194,000 per year. The IRS adjusts these limits annually: for 2017 they are $133,000 and $196,000 respectively.
You may contribute to both a traditional and a Roth IRA, though there is an annual contribution limit—for 2016, the maximum is $5,500 (or $6,500 if you are 50 or older).
IRAs for the self-employed
According to the U.S. Department of Labor, 15 million Americans are self-employed. For these individuals, a simplified employee pension, or SEP IRA, can be a good option. These accounts allow you to set aside as much as 25 percent of your net earnings from self-employment, up to $53,000 through 2016.
SEP IRAs work like traditional IRAs, which means you don’t pay taxes on your contributions and earnings until you withdraw them in retirement. There is no Roth option for SEP IRAs.
Savings IRAs vs. investment IRAs
Once you determine your account type, you may be able to choose between an investment IRA and a savings IRA. Your financial health, life stage and retirement goals can help you determine which kind of IRA to put your funds into. Savings IRAs are offered by banks and feature FDIC-insured CDs and money market savings accounts. These are low-risk accounts that offer the potential for relatively stable, modest yearly returns, often without any annual or custodial fees.
Investment IRAs are offered by investment firms and may allow you to invest in stocks, bonds, exchange-traded funds (ETFs) and mutual funds. These accounts make sense for those who are willing to accept some risk in their retirement accounts in exchange for the potential for greater long-term growth. Investment IRAs are not FDIC-insured, are not bank guaranteed, and have the potential to lose value.
No matter which kind of IRA you choose, saving or investing for retirement should be at the top of your list of financial priorities. With retirements lasting longer than they used to, the sooner you start preparing, the better off you’ll be.
Investing involves risk including loss of principal.
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