IRAs can be a good way to save for retirement, but there are several types to choose from, each offering different tax benefits and rules.
- An Individual Retirement Arrangement (IRA) is a type of retirement account for individuals that offers several tax advantages. There are several types of IRAs.
- Depending on the type of IRA you have, you pay either pre-tax or after-tax dollars and invest the funds in various assets.
- IRAs offer more investment flexibility than 401(k)s, which are employer-sponsored plans.
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An Individual Retirement Arrangement, or IRA, is a type of retirement account for individuals that allows you to both save and invest for retirement.
Many people use IRAs to augment other retirement accounts and take advantage of their many tax benefits. Depending on the type of IRA you choose and what is covered later, contributions may be tax-deductible or you may enjoy tax-free withdrawals in retirement. "IRAs are simple and an extremely easy investment plan to save for your retirement years," says Wilson Coffman, president of Coffman Retirement Group.
How do IRAs work?
With an IRA, you contribute money to the account at your convenience throughout the year. You can then use the funds to invest in a variety of assets, including mutual funds, index funds, stocks, bonds, ETFs and other investments. As these assets increase in value, so does the value of your IRA.
To open an IRA, go through a broker or local bank. "IRAs are extremely easy to set up and setup," Coffman says. "Most banks offer an IRA and every brokerage firm will offer IRA accounts. There are also many investment firms, such as Fidelity, that can also offer investment platforms for online retirement accounts."
Once established, you fund the account with bank payments, checks or, if you have other retirement accounts, a rollover.
Quick tip: To transfer funds from another retirement account, you can do a direct transfer or a trustee-to-trustee transfer by contacting your existing plan's administrator. You can also take a distribution yourself and deposit it in your new IRA, but this must be done within 60 days.
IRA contribution limits
The IRS has set contribution limits for IRAs, but the exact amount depends on your age, your taxable compensation for the year and the type of IRA you set up.
Here's how IRA contributions break down for 2021:
Types of IRAs
There are several types of IRAs, each with its own contribution limits, tax structures and use cases.
The top four include:
- Traditional IRA: This type of IRA is funded with pre-tax earnings. Contributions are tax-deductible, and you pay taxes on the funds when you withdraw them in retirement. They are usually best if you expect your tax bracket to be lower in retirement.
- Roth IRA: With Roth IRAs, you fund the account with after-tax earnings. This allows the money to grow tax-free, and you don't pay additional taxes when you withdraw it. They are a good option if you know your tax bracket will be higher in retirement.
- SEP IRA: SEP IRAs are for self-employed individuals or small businesses. They have much higher contributions than traditional and Roth IRAs and are taxed upon withdrawal.
- SIMPLE IRA: SIMPLE IRAs are a different type of retirement account for small businesses. These are also funded with pre-tax dollars and taxed once you withdraw money.
Most people choose between traditional and Roth IRAs. According to Clark Howard, author and host of The Clark Howard Podcast, future taxes should play a big role in deciding between the two.
"The biggest difference between a traditional IRA and a Roth IRA is the treatment of taxes," Howard says. "In general, tax rates are likely to increase over the years, regardless of which political party is in power. This means it may make more sense to skip the tax deduction you get with a traditional IRA to avoid taxes later by investing with a Roth IRA."
Advantages and disadvantages of IRAs
IRAs can be a good way to save for retirement, but they're not perfect. As with everything, they have both advantages and disadvantages.
On one hand, they come with many tax advantages and can allow you to invest your money in a variety of assets. On the other hand, there are age limits on when you can withdraw money (or face a penalty), and in many cases contribution limits can be lower than other types of retirement accounts. With 401(k)s, for example, you can save up to 19.Contribute $500 annually.
- Many tax benefits, including tax deductions and tax-deferred growth
- Allows you to invest in a variety of assets
- Several types to choose from
- Lower contribution limits than some other retirement accounts (4
- Early withdrawal penalty of 10%
- No employer contributions, as with 401(k)s
IRA vs. 401(k)
401(k)s are another popular type of retirement account, but they differ greatly from IRAs. Here's a quick look at their key differences:
- Individual Plan
- Funded with either pre-tax or after-tax dollars
- Traditional and Roth IRAs have a contribution limit of 6.000 USD per year
- Can pick and choose your investments
- No employer contributions
- Employer-sponsored plan
- Funded with pre-tax dollars
- Contribution limit of 19.$500 per year
- Allow 401(k) loans if you need money before retirement
- Limited to the investment options chosen by your employer
- Can come with employer contributions
The financial takeaway
An IRA is just one of many retirement account options, and there are several types to choose from. The right choice depends on your individual retirement goals and schedule, as well as your expectations for future taxes.
If you're not sure which retirement account or type of IRA to choose, consider talking to a financial advisor or tax professional. They can point you in the right direction.
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