I-R-A. Who knew three letters could be so daunting yet yield so many benefits for our financial lives?
IRA stands for Individual Retirement Account. And if you’re like most people, you likely think it sounds like a fancy investment tool that is reserved for people with loads of money and an unattainable level of financial savvy-ness.
But the truth is IRAs are an excellent type of investment account that virtually anyone looking to save for retirement can obtain and contribute to regardless of how much money they have to invest. There are also some notable tax advantages.
What is an IRA?
The purpose of an IRA is to invest money for retirement. Any person can open one; some individuals even have the opportunity to open an account through their place of employment. The money contributed to these accounts is invested and gains interest over time, exponentially growing your earnings the more you contribute. That helps you gradually build a nice nest egg for retirement. Whether you plan to retire five years from now or in 30 years, contributing to an IRA as soon as possible gives your money the chance to grow interest for the longest amount of time before you need it.
There are two main types of IRAs — traditional and Roth. Roth IRA contributions are made with money that’s been taxed, and traditional IRA contributions are made with money before taxes are taken out. As a result, withdrawals from a Roth IRA are not taxed as income when you use them in retirement, and traditional IRA withdrawals are taxed. Another difference between the two is that Traditional IRAs require a minimum distribution by April 1 of the year you turn 70 ½ years old – even if you don’t want to receive distributions yet. Roth IRAs do not require a minimum distribution at any point.
The contribution limits for each account are also important to know. Both accounts have a maximum amount of money you can contribute each year. In 2021 and 2022, you can contribute up to $6,000 per year to both accounts ($7,000 if you are 50 or older).
Tax advantages of an IRA
Both traditional and Roth IRA contributions have their own unique tax advantages.
If you contribute money to a traditional IRA, you qualify for a pretty hefty tax break that year. That’s because those contributions reduce your taxable income, which means you pay fewer taxes during that year. In return, however, you have to pay income taxes on that money when it’s distributed to you during retirement.
For example, if you make $50,000 per year and contribute $5,000 to your traditional IRA, your taxable income is actually $45,000. To calculate how much you can save in taxes by contributing to a traditional IRA, take your federal tax bracket percentage multiplied by your contribution amount. For instance, if you are in the 28 percent federal tax bracket and contribute $5,000 to an IRA that year, multiply $5,000 by 0.28. That equals $1,400 you won’t owe in taxes that year.
If you are right on the edge between two tax brackets, contributing to a traditional IRA could bump you into a lower tax bracket. Having a lower taxable income could also help you qualify for other tax incentives, such as claiming more credits.
On the flip side, Roth IRA contributions are made post-tax, meaning your contribution amount is counted as income even though it went straight to your IRA. For example, if you earn $50,000 but contribute $5,000 to a Roth IRA, your taxable income is still $50,000. If you contribute to a Roth IRA, you won’t receive a tax break on the year you make the contribution. However, the income you receive from your Roth IRA distributions during retirement will not be taxed.
The amount of money you save on taxes for a Roth IRA is hard to predict and varies based on your financial situation in retirement. But at the very least, you won’t pay any taxes on those distributions.
How to start contributing to an IRA
Starting an IRA account is easy! If you are traditionally employed, ask your employer if they offer any IRA options. Follow their process for getting it set up. Some employers will even match your contribution. For instance, if you contribute the $6,000 maximum per year, your employer may match that amount, which bumps your contribution up to $12,000.
If opening an account through an employer isn’t an option for you, you can always set one up yourself. If you want to manage the IRA, you can open an account through an online broker. You can also work with a financial advisor to manage the details for you.
To set an account up, just decide which type of IRA account you want to open and if you want to use an advisor. From there, your advisor of choice will provide direction. Once the account is established, you can contribute money from your bank account or rollover money into your IRA from other types of accounts, such as a 401(k) or another type of IRA.