Mortgages, car payments, insurance, utility bills, and other everyday expenses. It all piles up so quickly. All too often, you’ll feel like saving for retirement seems like a distant priority. However, a startling one-third of Americans have less than $5,000 put away for their post-work years. Even worse, roughly 21% have nothing saved at all. To complicate matters, experts are predicting difficult times ahead for the Social Security program.
These factors have personal finance gurus up in arms. They are urging everyone to start forming long-term financial plans. For most people, the thought of barely scraping by in old age is a frightening one. To prepare, you should take decisive action. It’s simply a savvy financial move. If this strikes a chord with you, IRAs are a tool you’ll want to know about.
What’s an IRA?
“IRA” stands for “Individual Retirement Account.” IRAs function as tax-sheltered investment vehicles you can use to accelerate your retirement savings. They allow you to earn tax-free or tax-deferred investment returns. They also greatly enhance their value over long periods of time compared to regular interest-bearing savings accounts. To open one, you’ll need to visit an authorized financial institution.
What’s The Difference Between an IRA and a 401(k)?
Even if you’re new to the world of retirement savings, you have probably heard of IRAs and 401(k) plans. However, you might not know the difference between the two. IRAs and 401(k)s rank as the two most common and popular retirement savings vehicles, but they are not the same thing. The basic dissimilarity is that IRAs are opened by individuals, whereas 401(k) plans must be offered through an employer. Many companies provide 401(k) plans as part of their benefits programs.
While IRAs and 401(k) deliver similar tax advantages, they are subject to very different rules. For example, both defer taxes on earnings until the account holder withdraws money. However, their contribution limits are very different. Also, 401(k) plans often come with age or tenure requirements. Meanwhile IRAs allow account holders to contribute income earned until the age of 70 and a half. Many other differences apply too. If you need help determining which of the two options is better for your particular situation, seek professional advice.
Remember that you are permitted to hold both an IRA and a 401(k) at the same time. However, your ability to take full advantage of either one may be limited, depending on how much money you make.
Are There Different Types of IRAs?
IRAs come in three forms.
Traditional IRAs
These IRAs are funded with money you might otherwise have been able to deduct from your personal income tax return. Traditional IRAs use tax-deferred structures that allow your investment to grow tax-free until you withdraw the money. Since most people end up in lower income brackets after they retire, traditional IRAs can deliver powerful savings.
Roth IRAs
The most common alternate is the Roth IRA. It’s funded with money you have already paid tax on. Unlike traditional IRAs, Roth IRAs allow account holders to make tax-free withdrawals after retirement if all terms and conditions are met.
Rollover IRAs
This less common type of IRA is funded with money drawn from another qualified retirement savings vehicle, like a 401(k) or a 403(b). These funds are “rolled over” from the old account into the new one, which is where the name comes from.
Most people are best-suited to traditional or Roth IRAs. You can use this handy calculator to help you decide which of the two is better for you.
Contribution Limits
Internal Revenue Service (IRS) guidelines for 2020 impose the following contribution limits on IRAs.
- Your total contribution cannot exceed $6,000 if you’re age 49 or under.
- If you’re age 50 or older, you are allowed to deposit assets worth up to $7,000.
- If your income for the year was below these thresholds, your maximum contribution is equal to your taxable income.
Note that qualified types of reservist payments as well as rollover payments do not count toward these contribution limits.
Importantly, IRAs allow you to apply a wide range of asset classes to the account. In addition to direct cash deposits, you can use IRAs as a tax-sheltered holding place for securities, certificates of deposits, bonds, and real property. By contrast, 401(k) plans only accept cash contributions. However, IRA holders must adhere to annual limits on total contributions, regardless of the type(s) of assets used to reach those limits.
Tax Deduction Limits
While you cannot claim income tax deductions for contributing to a Roth IRA, you may be able to enjoy some relief for your traditional IRA contributions. These regulations are complicated, but they basically break down in two ways.
The first set of rules applies if you have additional retirement savings accounts through your employer. The 2020 limits for these types of tax deductions are summarized in this IRS document.
The second set of rules is if you do not have an employer-based retirement savings plan. You can consult this table from the IRS to learn more about 2020 limits for people in this category.
How and When to Access IRA Funds
You are allowed to access the funds contained in your IRA account at any time. However, if you receive IRA distributions before you reach the age of 59 and a half, you will be subject to a 10% penalty for making an early withdrawal. This penalty is applied on top of any income tax obligations you might have to pay on the money. IRA distributions are considered income for personal tax purposes.
The easiest way to avoid the 10% penalty is to wait until you are older than 59 and a half to set up distributions. You are required to start receiving distributions once you reach the age of 70 and a half. The prevailing wisdom suggests you should avoid accessing the assets in your IRA account as long as possible.
If you pass away before accessing part (or all) of the funds in your IRA, you can leave the remainder to a beneficiary. Special rules apply to IRA funds that you give or receive as inheritance.
Defining Your Savings Goals
How much you need to save for retirement is one of the biggest financial questions you’ll ask when starting out with IRAs. There is no single right answer. The best course of action depends on what you plan to do during your retirement. If you want to travel, dine out, and enjoy memorable experiences that you were too busy to pursue during your working years, you’ll need to save more. Conversely, if you anticipate a low-key retirement lifestyle, you can probably get by with less.
Personal finance experts configure retirement savings targets in various ways. Here are some common rules of thumb you should keep in mind.
- Create a plan that delivers 60% to 85% of your pre-retirement annual income.
- Save 10% to 15% of your income for retirement, if start saving in your 20s. Save 20% to 25% if you start saving in your 30s. Then save as much as you can possibly afford if you start in your 40s.
- Save $15 to $20 for every one-dollar gap between your projected Social Security income and your anticipated living expenses during your retirement years.
A licensed financial professional will be the best source of personalized advice, so don’t hesitate to seek one out if you need planning assistance.
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