Once you get employed, the thought of retirement may cross your mind at some point. That can be the time you might think of making savings and investments. So that you still have some income at the time of your retirement to keep you going. Well, you may have a retirement plan at work or want to open an IRA to help you achieve this goal. But what is an IRA? How much can you contribute to your IRA? There are so many exciting questions coming up, which leads to the different IRA types.
This article will talk about IRAs and why you should invest in them. Please keep reading to find out.
What Is An IRA?
An Individual Retirement Account (IRA) is an investment account set up on a financial institution that allows one to save for their retirement on a tax-free basis. Therefore, these accounts are for retirement savings and offer valuable tax benefits. Moreover, IRA investments could include stocks, bonds, and mutual funds.
Characteristics Of An IRA
If you want to know how IRA works, the following characteristics could help.
- You can open an IRA account with a financial institution, approved to offer the Internal Revenue Service (IRS) account. Such institutions could be banks, brokerage companies, insured credit unions, or savings and loan associations.
- You can invest money in these accounts. There are many possibilities, such as stocks, bonds, mutual funds, or any other asset. Your investment and contribution over time will determine how your IRA grows.
- There are annual contribution limits in IRAs. Notably, you or your spouse can’t contribute more than your earnings to an IRA account.
- IRAs have withdrawal rules. Typically, there is an early withdrawal penalty of 10% if you withdraw the money before 59 and a half.
How Much Can I Contribute To My IRA?
It is essential to know that IRAs have annual contribution limits raised every few years due to inflation. For the years 2020 and 2021, an individual investor below 50 years of age can contribute $6,000 per year. However, those older than 50 years can save up $1,000 extra, which is the catch-up contribution, for a total of $7,000.
Types Of IRAs
We want to show you the different IRA accounts in a quick overview. The following are some of the most common types of IRA.
1. Roth IRA
A Roth IRA allows qualified withdrawals on a tax-free basis under certain conditions. It was established in 1997 and is provided by most brokerage firms both online and physically. Furthermore, a set income limit restricts high earners, depending on the tax-filing status and the modified adjusted gross income (MAGI). Nonetheless, the contributions made are not tax-deductible. Once withdrawals begin, the money becomes tax-free.
Additionally, the individual with this account can maintain it indefinitely. You can withdraw your earnings, but this may involve penalties and taxes depending on an individual’s and account’s age. Furthermore, even those covered by their employers’ retirement plans can also contribute to Roth IRA.
How Much Can You Contribute To A Roth IRA?
It is important to note that you can only contribute to this account if your income is below a specific amount. In 2021, the amount an individual below 50 years can contribute is $6,000. For those aged 50+, IRA provides a catch-up contribution, which gives room for them to contribute an extra $1,000, hence a total of $7,000. Importantly, all regular contributions must be in the form of cash, not assets.
2. Traditional IRA
Contributions in this type of IRA usually are tax-deductible. Therefore, the individual’s taxable income decreases by the amount of input. However, when you withdraw the money upon retirement, the regular tax rates apply. The deposit for those under 50 years is $6,000, and for those above, they can contribute up to $7,000 annually.
3. SEP IRA
A Simplified Employee Pension IRA (SEP-IRA) is an IRA for self-employed or small-business owners with few or no employees. Their contributions are tax-deductible. However, their investment grows tax-deferred until the individual retires. Additionally, their contribution limit can total up to nearly ten times the average amount ($6000). The contributions are limited to 25% of compensation. Moreover, the minimum distribution begins at the age of 72.
4. Simple IRA
Savings Incentives Match Plan for Employees Individual Retirement Accounts IRAs (SIMPLE IRAs) are IRAs for small businesses with less than 100 employees. Their contributions are tax-deductible, and the employer must contribute. Additionally, their investment grows tax-deferred until the individuals retire. The employee contribution limits in 2020 and 2021 are $13,500 for individuals below 50. Those who are above 50 years can make an additional catch-up contribution of $3,000.
5. Rollover IRA
A Rollover Individual Retirement account is an account that allows an old employer-sponsored retirement account to transfer assets to a traditional IRA. This procedure helps to maintain the tax-deferred status of the assets. They are generally used to hold profit-sharing plan assets. Moreover, most rollover IRAs are executed through direct transfer or by check. In some cases, the assets can be rolled over to a traditional IRA or converted to a Roth IRA.
Why Invest In An IRA?
Is there any need to invest in an IRA? Well, it makes sense to do so. An IRA can help you save money for your retirement, as you get tax breaks in the process. Also, your workplace retirement plan may not provide you with enough income when you retire. When you invest in an IRA, you prepare yourself better for retirement, and it allows your savings to grow faster than taxable accounts.
The Restrictions Of An IRA
Anyone who thinks they are making more money now than in retirement can put in a Roth IRA to reduce their tax liability in old age. If you make a total contribution to your traditional IRA, a so-called “back door” is also an option that allows you to contribute directly to Roth IRAs. The basic idea behind a back door or Roth IRA is that you get total contributions from the traditional IRA and turn them instantly into a regular IRA. There is no age limit on contributions to the Roth IRA as long as you have earned income. However, the age at which you can contribute to Roth IRAs can be up to your age, and there are no income restrictions.
If you earn more than the income limit, there is no way to store your money in a Roth IRA, so you only have to pay taxes through the back door. If you earn too much to contribute to your Roth IRAs, you can earn enough to ensure that your traditional IRA contributions are deductible on your tax return. The difference between a traditional IRA and a regular IRA is that the Roth IRA does not require you to withdraw money from the IRA until you are 70.
The Bottom Line
When at our workplaces, the thought of what will happen next after retirement may cross your mind. Why not be prepared for that time? IRAs allow you to do so, tax-free hence making your savings grow faster. With some retirement plans, you can’t achieve some of the benefits, and the fact that you are under a retirement plan doesn’t mean you can’t open an IRA. Take the opportunity to think about saving and investing in your retirement.
