Many people work hard all their lives, only to find that they don’t have enough money when they’re ready to retire. They prayed their nest egg would grow and mature, but it did not.
Why is this happening?
In most cases, the problem is with stagnant investments. People must remember that IRAs are intended for retirement — not funding a trip around the world or an exotic car.
So if you have ever wanted to contribute to an Individual Retirement Account, there are some things you should know about these investment accounts before opening one.
Want to learn more about what an IRA is and the different types of IRA? Scroll down below for more information.
What is an IRA?
IRAs are retirement accounts that give you tax benefits as a reward for saving money for retirement. You can open an IRA at a bank or credit union or with a brokerage firm.
The money in an IRA grows tax-free until it’s withdrawn — in retirement — when it will be taxed as ordinary income.
You generally pay no taxes on withdrawals from traditional IRAs until you reach age 59½ without penalty.
Still, once you start taking distributions, they’re subject to income taxes and a 10% penalty unless you meet certain conditions.
What Are The Types Of IRAs?
The two most common forms of IRAs are traditional and Roth accounts. Both have different rules and tax implications, so it’s essential to understand the difference between these two types of IRAs. So let’s go ahead and discuss the other features of each below.
Traditional IRAs
A traditional IRA allows you to deduct the number of contributions from your taxable income each year, lowering your current tax bill. It also grows tax-free until withdrawals begin after age 59½.
The main drawback is that withdrawals are taxed as ordinary income at your then-current rate when taken before age 59½.
An individual may contribute up to $5,500 annually (or $6,500 if you’re 50 or older). In addition, because it’s a deductible account, you’ll pay less tax today than if you invested elsewhere.
For example, if you earn $50,000 per year and contribute $5,500 to an IRA account, you will reduce your taxable income by $5,500 — lowering how much tax you owe by about $1,250.
Roth IRAs
A Roth IRA works differently than a traditional IRA because there’s no upfront tax break for contributions.
Instead, you pay taxes on your contributions when you make them and then enjoy tax-free growth for as long as you keep the money invested in the account.
However, any withdrawals (including earnings) after age 59½ are tax-free.
How Does An IRA Make Money?
The following are three ways IRAs make money:
Interest
This is the most common and least risky way an IRA makes money. When you deposit money into an account, it earns interest at a rate determined by the U.S. Treasury bills, notes, and bonds market price.
Dividends
Some mutual funds pay dividends to shareholders each year, which can be reinvested or taken as cash.
If you invest in a mutual fund that pays dividends, you’ll benefit from sharing in its profits — provided the fund continues making good decisions about where to invest its assets and how much risk it should take on as it grows over time.
Capital gains
Suppose you sell securities that have increased in value since they were purchased and reinvest those proceeds into more profitable investments within 60 days of selling them.
In that case, any capital gains on those securities are considered short-term (STCG) and are taxable at ordinary income rates up to 39.6%.
What Are The Disadvantages Of An IRA?
There are some disadvantages to IRAs. Let’s discuss each one below.
You have to pay taxes on your contributions.
The money you put in an IRA is pre-tax, meaning it’s not taxed until you withdraw it. But when you take it out, you’ll owe taxes. So your 401(k) has a better tax advantage than an IRA.
You can’t add to your account once you’re 70½ years old.
Once you reach this age, you won’t be able to contribute any more money to your account unless you roll it into a Roth IRA.
Or you can convert it so that the original contribution becomes taxable income (potentially subject to penalties if it isn’t rolled over properly).
You can’t withdraw funds without penalty if you use them for certain purchases before age 59½.
You’ll owe a 10% penalty on any withdrawals made before age 59½ if they’re used for non-qualified expenses like buying a car or paying off credit card debt (unless used for medical care).
This includes withdrawals from Roth IRAs as well as traditional IRAs. The good news is that there’s no penalty if you need the money for emergencies.
Is It Better To Have A 401(k) or an IRA?
IRAs and 401(k)s are two different retirement accounts, but they offer tax benefits and allow you to save money for retirement.
The most significant difference is that IRAs are available to people who don’t have jobs, while 401(k)s are only available if your employer offers a plan.
There are also some similarities between the two accounts, including that you can invest in them after-tax dollars if your income is too high to qualify for a tax deduction.
How Much Money Do You Need To Open An IRA?
You can open an IRA with as little as $5 in some banks and credit unions. However, some financial institutions require higher minimum investments.For example, most traditional IRAs require at least $1,000 to open an account. Roth IRAs typically have even higher minimums — usually around $5,000 or more.
Some brokerage firms also require this amount as a starting point when investing in stocks and bonds through their platforms.
In addition, the amount that you can contribute to an IRA can also be based on your income.
If you’re single and make less than $56,000 annually, you can put up to $6,000 into an IRA each year.
If you are married and filing jointly, the limit is $6,000 per person. That means if you’re married to a spouse who makes more than $56,000 per year, you could put away $12,000 into an IRA annually.
If you’re married filing separately and make less than $10,000 per year together (or $5,500 if one spouse makes more), then you are eligible for a Roth IRA contribution limit of $5,500 ($6,500 if 50 or older).
Can You Lose Money In An IRA?
The answer is “yes.” You can lose money if you take it out before 59 1/2.
If you take a distribution from an IRA before the age of 59 1/2, then the IRS will consider that a premature withdrawal and penalize you with 10 per cent in income taxes on top of that distribution.
That’s why they call them RMDs (required minimum distributions).
The IRS wants it cut no matter what, so they require people over 70 and a half to withdraw a certain percentage of their account yearly.
But you can’t lose money indefinitely if you leave the money in your IRA.
Final Thoughts
Investing in IRAs can provide tax advantages much greater than the regular 401(k)s offered through work and traditional IRA CDs.
They are a great way to save money while building an investment portfolio that you can hopefully leave to your family or charity in the future.
But, if your employer offers a 401(k) plan, it is strongly recommended you participate at least enough in your company’s plan to take advantage of any employer matching funds, if available.
There are also several things you must consider before opening an IRA, and the right one for you might not necessarily be the same for someone else.
Thus, it’s always best to take some time to learn more about IRAs rather than wait until it’s too late.
You never know–thanks to these accounts and their tax advantages, you may have significantly more money in your pocket or a better-funded retirement account.
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