As you prepare to retire, your investment strategy should change. Rather than keeping all your money in high-risk investments such as stocks or crypto investments, it’s important to diversify and consider retirement savings accounts. If you’re approaching retirement and your money is all in risky investments, it may even be a good idea to sell stock to fund a Roth IRA.
Various retirement plans include 401(k)s, 403(b)s, pensions, and IRAs. This article will be your guide to Individual Retirement Accounts, how they work, the types of IRAs, and everything you should know about IRAs to make an informed decision.
IRAs Explained
The first thing this guide to Individual Retirement Accounts will focus on is providing a straightforward explanation on what an IRA actually is.
An Individual Retirement Account (IRA) is an investment account with tax advantages to help you save for your retirement. Anyone who earns an income can open an IRA account.
You can open an IRA account from any institution approved by the IRS (Internal Revenue Service). Such institutions include banks, federally insured credit unions, savings and loan associations, and brokerage firms.
How IRAs Work
When you invest in IRAs, your money will compound and grow over the years. You can use the funds you’ve been contributing to your IRA account to invest in bonds, stocks, CDs, etc. This is one difference between 401(k)s and IRAs. With 401(k)s, what you can invest in is more limited.
IRAs are pretty flexible in that you can freely move your money from one asset investment to the next without incurring taxes. For instance, you can transfer money from bond investments to stocks.
However, there are contribution limits and withdrawal rules connected to these accounts. For example, you can’t contribute more than $6,000 annually for a traditional IRA if you’re less than 50 years old. However, if you’re 50 and above, you may be allowed to contribute a little bit more.
With an IRA, you can’t take your money out of the account until you are at least 59 and a half years old. If you do, you face a 10% penalty on the total amount withdrawn. But there are some exceptions to this rule. For example, you may be able to withdraw money to pay for your education or purchase a first home.
IRAs are meant to help you save for retirement. So, allowing you to withdraw early would defeat their purpose.
Why You Should Invest in an IRA Plan
One benefit of opening an IRA account is that you’ll have several investment options to choose from. These various options grow your money fast, giving you considerable retirement income. This level of growth is not found with pension plans or 401(k)s.
Additionally, you get to save on taxes and enjoy the flexibility that comes with IRAs. Can I trade options in my IRA account? Yes. Besides shifting investment assets, you can trade options in your IRA account. That is, you have the right to buy calls and sell puts for a given period at a set price.
You might also be wondering, can you trade futures in an IRA? Yes, you can trade futures in IRAs if you qualify.
Different Types of IRAs
There are several types of IRAs, but the four popular types include traditional, ROTH, SEP IRA, and SIMPLE IRA.
Traditional IRA
You can open as many traditional IRA accounts as you want, but the total contributions can’t exceed the annual limit. In 2021, the contribution limit for a traditional IRA account is $6,000. However, if you are 50 years or older, you can contribute up to $7,000.
The contributions you make to traditional IRAs are tax-deductible. That means your taxable income will decrease by the amount you put in the account. However, the money is taxable when withdrawing from this account in retirement since it’s treated as ordinary income.
Your contributions are deductible if you’re filing with your spouse and neither of you has a workplace retirement plan, regardless of your income. But if you have a retirement plan, the deductible amount reduces or is eliminated once your income reaches a certain point.
Withdrawals from a traditional IRA account before the age of 59 ½ attract a 10% penalty unless you’re taking the money for the specified exceptions.
Also, you must start taking the required minimum distributions once you reach 72 years.
Roth IRA
The contributions towards this account are not tax-deductible. Instead, withdrawals are tax-free.
Contribution limits for Roth IRAs are similar to those of traditional IRAs. However, you can only contribute if your Modified Adjusted Gross Income (MAGI) is less than $140,000 for single filers and $208,000 for married people filing jointly.
Your contributions towards your Roth IRA should only be in check or cash. Basically, you can’t use stocks to fund it. However, you can sell stocks to fund a Roth IRA with cash or cheque.
Unlike traditional IRAs, you don’t have to withdraw the money in retirement if you don’t need it. Instead, you can continue contributing towards the account if you have an eligible income.
SEP IRA
The simplified employee pension (SEP) IRA is mainly for self-employed individuals, such as contractors, small business owners, and freelancers.
Your contributions to these accounts are tax-deductible. However, your withdrawals are taxed as income.
In 2021, the contributions to SEP IRAs are limited to $58,000 or 25% of compensation, whichever is less.
SIMPLE IRA
SIMPLE IRA stands for Savings Incentive Match Plan for Employees Individual Retirement Accounts. The type of IRA is typically for small businesses with 100 or fewer employees.
The contribution limits in 2021 are $13,500 annually for employees under 50 years and an additional $3,000 for those over 50 years.
Like a traditional IRA, the contributions are tax-deductible, but the withdrawals are taxed as income.
Conversion vs. Recharacterization IRA
One thing you need to know how to distinguish is a conversion vs. recharacterization IRA. Concerning IRAs, conversion is taking part of your balance from a traditional IRA and transferring it to a Roth IRA. Recharacterization is just the opposite. That is, moving your balance from a Roth IRA to a traditional IRA.
Difference Between 401(k) and IRA: Which One Is Better?
Individuals with 401(k) plans from their employers can still have an IRA account to boost their retirement savings.
The main difference between the two is that while employers usually offer 401(k) plans, you can get an IRA account on your own. Also, IRAs have more extended investment options than 401(k)s. These options allow you to grow your funds fast. However, 401(k)s allow higher contributions than IRAs.
Remember, you can move your 401(k) money into a rollover IRA account to avoid taxes and penalties on early withdrawals. So, the best option may not be to choose one or the other but to benefit from having both an IRA and 401(k) account.
IRA vs CD Difference
A certificate of deposit (CD) is an account where you deposit a fixed amount of money that is held in the account for a specified period. In return, your money earns interest.
While a CD is a savings tool, an IRA is a retirement investment-holding account with various tax benefits. This means there is more room for your money to grow in an IRA than in a CD.
How to Open an IRA
You can open your IRA with banks, brokerage firms, credit unions, and mutual fund companies. But not all of these companies offer the same benefits. To ensure you get the best possible deal, you’ll want to compare their minimum opening requirements and the fees involved. In this case, Robo-advisors and online brokers can be of great help.
Once you’ve chosen the right company for you, they will be able to help you easily open an IRA with them.
Is it Worth Getting an IRA?
IRAs offer great tax advantages, allowing you to grow your retirement investments. Whether you choose an IRA with deductibles on contributions and pay tax after withdrawals, or you pay tax now and make tax-free withdrawals later, you’ll enjoy tax benefits as your investments grow.
You also have a wide range of investment options, unlike 401(k)s. Getting an IRA is worth it. Banks, brokers, and Robo-advisors will help you open one.
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