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By Gabriella Cruz-Martínez
December 22, 2020
Rangely García / Money

An IRA, or individual retirement account, is an investment tool that allows you to grow cash on a tax-deferred basis until the money is withdrawn. The Internal Revenue Service created IRAs as another way to contribute to your retirement other than a 401(k).

What You Should Know:

  • Anyone can open an IRA account as long as they have earned income, even minors.
  • There are certain exceptions that allow the early withdrawal of your IRA contributions penalty-free.
  • Generally, however, withdrawing earnings before the age of 59 ½ is subject to a 10% tax penalty.
  • You can own more than one type of IRA.
  • Under the CARES Act, you can withdraw up to $100,000 from your Roth or traditional IRA penalty-free in 2020 if you’re under 59 ½ and have been affected by COVID-19.

Everyone dreams of retiring comfortably, but sometimes Social Security and pension benefits can fall short. This is when opening an IRA may come in handy. According to the Urban-Brookings Tax Policy Center, a nonpartisan think tank, ownership of IRAs has been shown to increase by age and income.

What makes IRAs so attractive are their tax benefits and easy access. Unlike a 401(k), which is an employer-sponsored retirement account, you can sign up for an IRA on your own. Another advantage is that anyone can open an account regardless of their age, as long as they have earned income from a W-2, 1099, or 1040 job.

Determining what type of IRA is right for you should depend on your income, both now and what you expect it to be in the future. Roth IRAs have income limits, so if your wages surpass those limits then you should consider a traditional IRA.

According to Alicia Munnell, professor of Management Sciences at Boston College’s Carroll School of Management and Director of the Center for Retirement Research, if you’re eligible for both a Roth and a traditional IRA, you should take a look at your tax expectations in the future.

“If you have a high income, a traditional IRA can allow you to defer paying income tax now and help you save toward retirement. If you would prefer to pay taxes upfront as you contribute and not worry about it later — a Roth can be a good investment.”

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The Perks of Traditional and Roth IRAs

Traditional and Roth IRA accounts are the most common types of IRA. A study by the Investment Company Institute, a global association of regulated funds, found that at least 36.1 million Americans had traditional IRAs as of 2019, and 24.9 million had Roth IRAs.

One of the main advantages of both traditional and Roth IRAs is that your investments will grow tax-free.

Differences
You can defer paying income tax on your contributions until they are withdrawn from your account. Your investments are made with after-tax dollars so that once you reach retirement you’ll get your savings tax-free.
Has no income limit. Has an income limit.
Has required minimum distributions (RMDs) starting at a specific age. As of 2020, the starting age is 70 ½ for those born on or before June 30, 1949, and 72 for those born on or after July 1, 1949. Has no required minimum distributions (RMDs,) meaning you can continue to let your savings grow indefinitely.
You may qualify for a tax deduction. Doesn’t include tax breaks.
There’s a 10% early withdrawal penalty on distributions before age 59 ½ unless the money is withdrawn due to an exception such as death, disability, funding education, medical expenses, a first home purchase, or the birth or adoption of a child. Withdrawals are more flexible. For one, you can withdraw contributions any time without penalty, since you've already paid taxes.

As for withdrawals on earnings, they are tax-free if you’ve had a Roth IRA for at least five years and you are 59 ½ (or older).

You can also withdraw tax-free at any age if you’ve had a Roth IRA for five years and qualify for certain exceptions, such as a first-home purchase.

As for withdrawals on earnings, they are tax-free if you’ve had a Roth IRA for at least five years and you are 59 ½ (or older).

You can also withdraw tax-free at any age if you’ve had a Roth IRA for five years and qualify for certain exceptions, such as a first-home purchase.

Similarities
You can grow cash tax-free.
You can open an account regardless of your age, as long as you have earned income.
You can contribute $6,000 per year in 2021 ($7,000 if you’re 50 or older), even if you’re also contributing to a 401(k) or other company-sponsored savings account.

What Kind of IRA Is Right for Me?

If you’re one of the many people thinking of starting a retirement savings account, it’s important to explore all of your options. The Internal Revenue Service created IRAs to give individual investors another way to save for retirement with a vehicle other than employer-sponsored 401(k) accounts. Opening an IRA is simple and most people invest in them to take advantage of their tax benefits, which help your money grow faster.

According to the Investment Company Institute, 46.4 million Americans — 36.1% of U.S. households — reported they owned IRAs in 2019, which include traditional, Roth, Simplified Employee Pensions (SEP IRAs), and Savings Incentive Match Plans for Employees (SIMPLE IRAs).

Each type of IRA has its advantages. Here’s a breakdown of what they consist of:

Type of IRA Definition Contribution limit
Traditional IRA A traditional IRA allows your contributions to grow tax-deferred until you withdraw them upon retirement. There are two main types of traditional IRAs: deductible and nondeductible. Your financial situation will determine whether or not you get a tax deduction on your contribution.
Non-deductible IRAs are similar to Roth IRAs in that contributions are made with after-tax dollars, but differ from them in that contributions aren’t limited by how much you earn.
For 2021, total annual contributions to your traditional IRA can’t exceed $6,000 ($7,000 if you’re age 50 or older). Your contributions can’t surpass your taxable compensation for the year.
Roth IRA A Roth IRA is funded with after-tax dollars, meaning you’ve already paid taxes on the money you put into it. In return, your money grows tax-free. Once you retire and withdraw your savings, you won’t pay any taxes. For 2021, total annual contributions to your Roth IRA can’t exceed $6,000 ($7,000 if you’re age 50 or older). Your contributions can’t surpass your taxable compensation for the year.
SEP IRA A SEP IRA (or Simplified Employee Pension) is a type of traditional IRA designed for self-employed individuals and small business owners with few employees. Like traditional IRAs, the money in SEP IRAs is not taxable until withdrawn. Unlike traditional IRAs, these are funded with employer contributions only. Contributions for tax year 2020 can be up to 25% of compensation or $57,000, whichever is less.
SIMPLE IRA Unlike SEP IRAs, employees are allowed to make contributions to a SIMPLE IRA (or Savings Incentive Match Plan for Employees). SIMPLE IRAs are most commonly used by small business start-ups with under 100 employees. Additionally, employers are required to match up to 3% of the employee’s salary or make nonelective contributions of 2%, up to an annual limit of $290,000 for 2021. As per the IRS, the amount an employee contributes from their salary to a SIMPLE IRA cannot exceed $13,500 in 2020 and 2021.
Spousal IRA Spousal IRAs are intended for married couples and allow the working spouse to contribute to an account on behalf of a spouse that earns little or no income. To qualify for a Spousal IRA, couples must file their income taxes jointly. It’s worth noting that Spousal IRAs are not co-owned. The IRS states that each spouse may contribute up to a current limit, however, the total of their combined contributions can’t exceed the taxable compensation reported on your joint income tax return.

Who Can Open an IRA?

To be eligible to open an IRA, you must have earned income. The Internal Revenue Service defines taxable income and wages as money earned from a W-2 job or self-employment. That means that just about anyone can open an IRA account, regardless of age.

A parent or legal guardian can set up an IRA for a minor through a custodial account. Once minors come of age (18 or 21 in certain states), they will have full access to their IRA account.

Types of IRA Rollovers

An IRA rollover — sometimes referred to as a "rollover IRA" — allows you to move money from your former employer-sponsored retirement plan to an IRA. Many people roll over their savings to consolidate former employer 401(k) plans and avoid the hassle of early withdrawal tax penalties.

However, there are some factors you should watch out for when rolling over your IRA. If done incorrectly, your rollover could be considered a distribution or early withdrawal and be subject to taxation.

Larry Sprung, CFP and founder and wealth advisor at Mitlin Financial shared two methods to avoid this.

“There are two methods that you can use to roll over money from one IRA to another. The easiest and least troublesome option is a direct rollover. With a direct rollover, you have the custodian of the current IRA write a check to the custodian of the new IRA for your benefit. And you as the IRA holder never take possession of the money,” said Sprung.

The second method is what they call an indirect rollover. Sprung warns that if you decide to take an indirect rollover, you'll receive a check to your name, which must be deposited within 60 days from when you receive it. If you fail to do so, the money will be completely taxable. You also need to make sure you're not selecting the option to withhold taxes when you complete the indirect rollover application.

“If you withdraw money from a 401(k), the default is to withhold 20% for tax purposes, it’s very common for people to make the mistake of inadvertently withholding taxes unless they specify otherwise,” said Sprung.

Another thing to note is that while the IRS allows only one indirect rollover in any 12-month period, there is no limit to the number of direct rollovers you can request.

“If you're looking to rollover money and it's not a direct rollover, you really want to consult a wealth advisor, financial advisor, or your CPA to make sure that you're filling out that paperwork properly. As so that you're not going to incur an unintended tax consequence,” said Sprung.

Depending on the plan you have, your investments could maintain their tax-deferred status when rolled over directly into an IRA account. Some qualified plans include 401(k), money purchase, profit-sharing, and defined benefits plans. If you're considering a Rollover IRA, verify whether your account qualifies for a rollover.

Rollover IRA quick Facts:
Most IRAs include Rollovers from Employer-Sponsored Retirement Plans
60% of U.S. households with traditional IRAs said their accounts contained rollovers from employer-sponsored retirement plans.
Six in 10 traditional IRA-owning households had rollovers from an employer-sponsored plan in 2019.
More than 80% of households that have an IRA also have either a pension or retirement savings account.
Source: Investment Company Institute, The Role of IRAs in US Households’ Saving for Retirement 2019

Watch for Early Withdrawal Tax Penalties

You can withdraw early from an IRA prior to age 59 ½, but the money may be included as part of your gross income and subject to a 10% additional tax penalty. However, tax penalties are waived if your early withdrawal is for a qualifying distribution or if you meet certain exceptions.

Where to Open An IRA

You can open an IRA account through a variety of financial institutions. In 2019, 75% of U.S. households that owned traditional IRAs held them through investment professionals, brokerage firms, banks, direct sources, mutual fund companies, and discount brokers. You can even open an IRA through an insurance company, although that’s not as common.

Before getting started, take your time comparing providers. While the IRS doesn’t require a minimum contribution to get an account started, some providers may require $500 to $1,000 as an initial deposit plus servicing fees, depending on the account. Other institutions may have a lower minimum deposit requirement or none at all, so weigh your options.

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