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Money SmartsMarch 11, 2022
What is an IRA?
An individual retirement account (IRA) is an investment account that helps you save for retirement.
There are four popular types of IRAs — traditional, Roth, SEP and SIMPLE — and all offer tax benefits that reward you for saving. You can open an IRA at credit unions and, depending on the type of IRA, your contributions may be tax-deductible, or withdrawals may be tax-free.
How do IRAs work?
Investing in an IRA allows your money to grow and compound. You can invest in stocks, bonds and other assets. How your account balance grows over time depends on how your account is invested and how much you contribute to the IRA.
IRAs have annual contribution limits. Generally, you must have earned income to contribute to an IRA. There are also withdrawal rules. You may face a 10% penalty and a tax bill if you withdraw money before age 59 1/2, unless you qualify for an exception.
What are the types of IRAs?
There are four popular types of IRAs: traditional, Roth, SEP and SIMPLE.
A traditional IRA is a tax-advantaged plan that allows you significant tax breaks while you save for retirement. Anyone who earns money by working can contribute to the plan with pre-tax dollars, meaning any contributions are not taxable income. The IRA allows these contributions to grow tax-free until the account holder withdraws them at retirement and they become taxable. Earlier withdrawals may leave the employee subject to additional taxes and penalties.
Contributions to traditional IRAs are often tax-deductible. For example, contributing $6,000 to a traditional IRA could reduce the amount of your taxable income by $6,000. Then, in retirement, withdrawals from traditional IRAs are taxable as ordinary income. The contribution limit for traditional IRAs in 2021 and 2022 is $6,000 per year. People 50 and older can contribute up to $7,000 per year.
If you're married and you or your spouse has a retirement plan at work, the amount of your traditional IRA contribution that you can deduct is reduced, or eliminated altogether, once you hit a certain income. You can still make contributions, but they won’t be tax-deductible. If you and your spouse don't have retirement plans at work, then you can deduct your IRA contribution no matter how much your income.
Generally, you can take distributions from a traditional IRA starting at age 59 1/2. If you take money out before then, you may have to pay a 10% penalty (there are some exceptions). You must start taking required minimum distributions when you reach age 70 1/2 or 72, depending on your birthday.
--Offers some valuable tax benefits, and it also allows you to purchase an almost-limitless number of investments – stocks, bonds, CDs, real estate, etc.
--No tax owed until you withdraw the money at retirement.
--Can be costly to access your money because of taxes and additional penalties.
--Requires you to invest the money yourself. You’ll have to decide where and how you’ll invest the money, even if that’s only to ask an adviser to invest it.
A Roth IRA is a newer take on a traditional IRA, and it offers substantial tax benefits. Contributions to a Roth IRA are made with after-tax money, meaning you’ve paid taxes on money that goes into the account. In exchange, you won’t have to pay tax on any contributions and earnings that come out of the account at retirement. It's an attractive option for investors who have a long time before they retire.
In 2021 and 2022, the annual contribution limit is $6,000 ($7,000 if 50 or older) for modified adjusted gross incomes below $140,000 for single filers in 2021 ($144,000 in 2022) or $208,000 for people married filing jointly ($214,000 in 2022).
--Ability to avoid taxes on all money taken out of the account in retirement, at age 59 ½ or later.
--Provides lots of flexibility, because you can often take out contributions – not earnings – at any time without taxes or penalties.
-- Can be opened by anyone. Your employer does not need to offer access to a Roth IRA as a benefit.
--You need to decide how to invest the money or have someone do that job for you.
--There are income limits for contributing to a Roth IRA.
SEP IRAs are for self-employed people or small-business owners with few or no employees. Similar to traditional IRAs, the contributions are tax-deductible. Investments grow tax-deferred until retirement when distributions are taxed as income. SEP IRAs require proportional contributions for each eligible employee if business owners contribute for themselves.
In 2022, contributions are limited to 25% of compensation or $61,000, whichever is less. In 2021, the limit was 25% of compensation or $58,000. There's no catch-up contribution at age 50+ for SEP IRAs.
SEP IRAs require minimum distributions beginning at age 72.
--For employees, this is a freebie retirement account.
--For self-employed individuals, the higher contribution limits make them much more attractive than a regular IRA.
--There’s no certainty about how much employees will accumulate in this plan.
--The money may be too easily accessible. If you tap the money before age 59 ½, though, you’ll likely have to pay a 10 percent penalty on top of income tax.
SIMPLE IRAs (Savings Incentive Match Plan for Employees Individual Retirement Accounts) are for small businesses with fewer than 100 employees. The same benefits are provided to all employees. Similar to traditional IRAs, the contributions are tax-deductible. Investments grow tax-deferred until retirement when distributions are taxed as income.
Employee contribution limits for a SIMPLE IRA in 2022 are $14,000 per year ($13,500 in 2021) for those under age 50. People age 50 and older can make an additional $3,000 catch-up contribution.
Employer contributions are mandatory. The employer has a choice of whether to contribute a 3 percent match or make a 2 percent non-elective contribution even if the employee saves nothing in his or her own SIMPLE IRA.
--Opportunity for workers to make pre-tax salary deferrals and receive a matching contribution. To the employee, this plan doesn’t look much different from a 401(k) plan.
--The employee contribution has a limit of $14,000 for 2022, compared to $20,500 for other defined contribution plans.
Is it better to have a 401(k) or IRA?
You can have both. You can get the full employer match on your 401(k), and open an IRA to boost your retirement savings.
If you don't get an employer match, if you plan to max out your 401(k), or if your 401(k) has narrow investment options or high fees, it might be a good idea to invest primarily in an IRA.
The big difference between an IRA and a 401(k) is that employers offer 401(k)s, while you would open an IRA yourself through a credit union.
If you have an old 401(k), you can also move that money into a rollover IRA. A benefit of a rollover IRA is that when done correctly, the money keeps its tax-deferred status and doesn't trigger taxes or early withdrawal penalties.
Savings account versus IRA
IRAs and savings accounts are two very different but very powerful financial tools. IRAs are helpful for preparing for retirement while savings accounts are great for housing money you need in the short term.
Taking full advantage of both and knowing how to use them will put you on the path to financial success.