What is an IRA?

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Are you trying to figure out the best way to save for retirement?

An IRA (Individual Retirement Account) allows you to save and also keeps your income tax bill as low as possible.

Almost anyone can open an IRA even if you have a 401k or pension plan.

You will need to decide if you want to open a traditional IRA or Roth IRA.

We will help you learn how an IRA works and how you can start saving for the future.

What is an IRA?

IRA stands for individual retirement account. The first IRAs launched in 1974 after Congress  passed the Employee Retirement Income Security Act.

Notably, you can contribute to an IRA and 401k at the same time.

These accounts let you invest in stocks, bonds, real estate and other fixed-income assets. The main benefit of investing with an IRA is that you pay fewer taxes on your investment gains.

You can invest in the same assets as your taxable non-retirement investment. However, you must report your annual investment income on your federal and state tax returns. With an IRA, you only pay a tax on your investments once.

There are two different IRA accounts you can open:

  • Traditional IRA (your contributions grow tax-deferred)
  • Roth IRA (your contributions grow tax-free)

Rollover IRAs are another common option. Your rollover account can either be a traditional or Roth IRA.

If you’re self-employed, there are a few other options that we will review later on. Which IRA account type you open determines when you pay taxes on your contributions.  

Traditional IRA

The first IRA account option was a traditional IRA. Until the Roth IRA started in 1997, a traditional IRA was your only IRA account type. Basically, your annual contributions reduce your taxable income for the current tax year and grow tax-deferred.

If you use an FSA for medical costs, the contributions rules are similar.

Traditional IRA Taxes

Traditional IRA contributions are an immediate tax benefit. Your contributions grow tax-deferred. Your taxable income is less for the current tax year. You only pay taxes when you withdraw money. 

Here is a quick example of how traditional IRA contributions work. If you contribute $5,000 in 2019, your taxable income is $5,000 less this year.

So if you make $50,000 pre-tax, your net taxable income is $45,000. Other popular tax deductions can reduce your taxable income too.

Traditional IRA withdrawals are subject to regular income taxes but not capital gains taxes. The IRS taxes your withdrawals the same as your paycheck. In other words, if you withdraw $40,000 per year, it’s like your annual salary is $40,000.

Because you pay income taxes on the withdrawal amount, you may need to withdraw more than you plan to pay the bills.

Required Minimum Distributions

Once you turn 70 ½ years old, you must start making required minimum distributions. You must withdraw a certain amount to avoid a 50% excise tax on the difference.

Roth IRA

The Roth IRA launched in 1997 with the Taxpayer Relief Act of 1997. This IRA type is named after Senator William Roth, who was the bill’s chief sponsor. 

All Roth IRA contributions grow tax-free. This means you pay income taxes on the contribution amount today. But you never pay taxes on that money again. Even your withdrawals are tax-free.

If you don’t want to guess what your taxable income in retirement will be, consider opening a Roth IRA.

Roth IRA Taxes

A Roth IRA won’t help you save money on taxes this year. But you will legally pay fewer taxes in the future. All Roth contributions grow tax-free. 

If you contribute $5,000, you pay income taxes on that entire amount for the contribution year. Under current tax law, you keep the full withdrawal amount. 

Rollover IRA

Perhaps you have a 401k with a former employer. If so, you can transfer it to your current employer’s 401k plan.

However, a potentially better option is opening a rollover IRA. This is because rollover IRAs have fewer fees and more investment options than 401k plans.  

For example, your 401k provider probably changes an annual $50 account fee. Most IRA providers don’t charge annual account fees.

You will most likely be able to keep your current 401k portfolio if you like it. Plus, rollover IRAs don’t count toward your annual contribution limit. 

A rollover IRA can either be a Roth or traditional IRA. In other words, your traditional 401k becomes a traditional IRA. And a Roth 401k becomes a Roth IRA. 

It’s also possible to convert a traditional 401k into a Roth IRA. Remember, you will need to pay income taxes on this amount. But your converted funds grow tax-free after that.

Spousal IRA

If you’re a stay-at-home parent and don’t earn taxable income, you can likely open a spousal IRA. Your spouse must earn a taxable income for you to qualify. 

As long as your annual household income is above $12,000, you and your spouse can contribute up to $6,000 to your IRAs. Spouses age 50 years or older can make an extra $1,000 catch-up contribution.

Custodial IRA

If your child earns income, they can open a custodial IRA. It can either be a traditional or Roth IRA. Once your child becomes a legal adult, they take full ownership of the account.  

Who Can Open an IRA?

Almost any person who earns taxable income can open an IRA. This includes young children and teenagers with a side hustle.

Even if you have a 401k or pension, you can open an IRA. Ideally, you will have a pension, 401k and IRA.

High-income households may not qualify for a Roth IRA under the current contribution rules. Income phaseouts start at $122,000 for single filers and $193,000 for joint filers.

If your modified adjusted gross income is higher, your annual contribution limit is less.

Although, you can still open a “backdoor Roth IRA” if you can’t make regular Roth IRA contributions. We’ll discuss this strategy later on in this article.

IRA Contribution Limit  

Like 401k plans, Roth and traditional IRAs have annual contribution limits. However, if you earn a high income, you may not be able to make a full contribution to a Roth IRA.  

Most people can contribute up to $6,000 into their IRAs for the tax year 2019. So if you have a traditional and a Roth IRA, you might contribute $3,000 into each. 

But if your annual taxable income is less than $6,000, you can only contribute up to the amount you earn. For instance, a teen with a $2,000 yearly income can only contribute up to $2,000.

Catch-up Contributions

Once you reach age 50, you can make an extra $1,000 catch-up contribution. So this means you can contribute up to $7,000 into your IRAs.

IRA Contribution Deadline

The annual IRA contribution deadlines are more flexible than other tax deductions. For example, 401k donations and charity donations must happen by December 31.

You can make contributions until the federal tax filing deadline.

For your tax year 2020 contributions, you have until April 15, 2021 to add up to $6,000 in funds.

If you’re looking to make a smart end-of-year money move, don’t forget the IRA contribution.

Traditional IRA Income Limits

You can no longer make new contributions to your traditional account once you turn 70 ½ years old. At this magic mark, you must begin taking required minimum distributions (RMDs).

There are no income phaseouts for traditional IRAs if you don’t have a 401k or employer pension plan. In particular, this is good news if you earn a high income and can’t make a full Roth IRA contribution.

If you earn a sizable income and have an employer pension plan, not all of your contributions are deductible.

Deduction phaseouts start at $64,000 for single filers and $103,000 for married couples. And no contribution is deductible when your modified AGI is $74,000 for singles and $123,000 for joint filers. 

You can still contribute to a traditional IRA if you have a high salary, and your contributions can grow tax-deferred. But you can’t claim the tax deduction on this year’s tax return. 

Roth IRA Income Limits

Roth IRAs have higher income phaseouts than traditional IRAs. Because Roth contributions aren’t tax-deductible, a workplace retirement plan doesn’t impact your income limits. 

There are no age restrictions, either, because you don’t have to take required minimum distributions at any age. 

Like traditional IRAs, the IRS uses a sliding scale for Roth IRA income limits.

Below are the Roth IRA income limits for your tax filing status.

Married Filing Jointly and Qualified Widowers

  • Up to full combined contribution: Modified AGI of $193,000 or less
  • Partial contributions: Modified AGI between $193,000 and $203,000
  • No contribution: Modified AGI above $203,000

You and your spouse can each contribute up to $6,000 into a Roth IRA of your household income is $193,000 or less. After that, check with your tax preparer to see your eligible contribution limit.  

Single Taxpayers

  • Up to full combined contribution: Modified AGI of $122,000 or less
  • Partial contributions: Modified AGI between $122,000 and $137,000
  • No contribution: Modified AGI above $137,000

Solo taxpayers can make a full contribution when their modified AGI is below. 

Excess IRA Contributions

If you contribute too much to a Roth or traditional IRA, you must pay a tax on the excess amount.

That current tax is 6%. To stop paying the tax, you must remove those funds from your IRA. If this happens to you, check with your stock broker to reverse a contribution.

IRA Withdrawal Rules

You can start making penalty-free withdrawals when you turn 59 ½ years old. Most early withdrawals are subject to a 10% penalty. Plus, your withdrawals are subject to ordinary income taxes.

The entire traditional IRA withdrawal is taxed at the current income tax bracket rules. Roth withdrawals are tax-free since you paid income tax on the initial contribution.

Roth IRA Qualified Distributions

All Roth IRA withdrawals are tax-free when you meet these two conditions:

  • You are at least 59 ½ years old
  • Your first Roth IRA contribution is at least five years old

In short, open your Roth IRA at least five years before you retire, and every withdrawal is tax-free. This five-year rule is only an issue when you open a Roth IRA within five years of making your first withdrawal. 

Here’s a brief example. If you open a Roth IRA when you turn 56 years old, you must wait until you become 61 to make penalty-free withdrawals. 

Early Withdrawals

You can make early IRA withdrawals before turning 59 ½. In most cases, you will pay a 10% early withdrawal penalty plus income taxes.

Some early withdrawal exceptions include:

If you have any of these expenses, try withdrawing from your non-retirement account first.

You will avoid the possibility of paying an early withdrawal penalty. And you’re not depleting your retirement savings before you reach retirement age. 

Which IRA is Better for You?

You can open one or both IRA types. The better option depends on when you want to pay income tax. Now or later?

Traditional IRA

A traditional IRA can be better if you want the immediate tax deduction. If you plan on withdrawing the same amount as your current annual income or less, your yearly tax bill shouldn’t increase. 

If you anticipate being in a higher tax bracket in retirement, a Roth IRA is better. Just remember that you may need to withdraw more than you need when you turn 70 ½.

At this age, you pay a 50% excise tax if you don’t withdraw enough to satisfy the required minimum distribution requirement. 

Roth IRA

The Roth IRA is better if you want tax-free withdrawals. Your taxable income is higher during your working years. Although it can be lower in retirement.

Plus, Roth IRAs don’t have required minimum distributions like traditional plans. You can withdraw your funds as you need them. This flexibility is also good as you may not want to be forced to make withdrawals you don’t need.

Less Common Types of IRAs

If you’re self-employed or earn a large income, you can open less-common IRAs. The traditional or Roth tax rules still apply, but the contribution limits differ.

SIMPLE IRA

A SIMPLE IRA lets your employer make matching contributions. And you can have more investment options than a 401k plan. Small businesses with fewer than 100 employees are the most likely to offer this IRA. 

Your employer has two contribution options: 

  • Matching contributions of up to 3% (the employee must contribute to earn the match)
  • 2% on employee salary (the employee doesn’t have to contribute)

All employee and employer contributions are tax-deferred like a traditional IRA. 

SEP IRA

Another version of the employer-IRA. A SEP IRA has higher annual contribution limits than a Simple IRA. Employers can contribute up to 25% of their employee’s salaries. This option is also available to the self-employed. 

Self-Directed IRA

A self-directed IRA lets you invest in something besides stocks and index funds. Physical assets include rental property or gold bullion.

You must usually use a specialty broker to open a self-directed IRA. The annual maintenance fees are higher than regular IRAs. 

Also, you will need to pay attention to the investment restrictions to avoid accidental tax penalties. 

For example, a rental property must be managed by a property management company, and the rental income must go into the IRA. 

Backdoor Roth IRA

A “backdoor Roth IRA” is a legal way for high-income earners to still have a Roth IRA. If you qualify for a doctor loan, you’re an ideal candidate for a backdoor Roth. 

While we won’t get into specifics, below is a brief overview of this retirement strategy:

  • Make non-deductible traditional IRA contributions
  • Convert these contributions into a Roth IRA
  • Pay taxes on the converted balance

You can make these indirect Roth contributions each year. 

Where to Open an IRA

Most online brokers let you open an IRA for free. However, you may need a minimum starting account balance like $500. You may open at the same place you have your 401k or taxable investments. 

Betterment

Betterment is one of the most effortless ways to open a Roth, traditional or SEP IRA. You only need $1 to make your first investment. And Betterment automatically invests in a variety of index fund ETFs. Also, Betterment rebalances your portfolio for an age-appropriate asset mix. 

Betterment is one of the best robo-advisors for its tax-optimized investment strategy. They use tax-loss harvesting to keep your tax bill low. Keeping your taxable and spousal accounts at Betterment makes it easier to optimize your investments.

Ally Invest

DIY investors will like the flexibility Ally Invest offers. You can open a self-directed account with a $0 opening balance. It costs $4.95 to trade stocks. There are commission-free ETFs ($0 per trade) from Vanguard, iShares and GlobalX.

Ally Invest also offers cash-enhanced managed portfolios that automate your IRA investing. With a $100 initial deposit, you can invest in one of these portfolio themes:

  • Income
  • Core
  • Tax-optimized
  • Socially responsible

These portfolios hold interest-bearing cash investments plus stock and bond ETFs.

M1 Finance

M1 Finance is another fee-free option. You need $500 to open a Roth, traditional or SEP IRA. But you won’t pay any trade fees for stocks or ETFs. And you can buy partial shares when your contribution can’t buy a full share.

Read our full M1 Finance review to learn more about how this free investing app works.

Fidelity

If Fidelity manages your 401k, you might open your IRA there as well. They are also one of the few brokerages to offer custodial IRAs. Fidelity also provides the less-common IRAs like the SIMPLE IRA.

All stock and ETF trades are free on Fidelity. They also offer a wide variety of index funds. Some of them have no fund fees, which means you may never pay any fee to invest.

Vanguard

Another sizeable online broker is Vanguard and is the best option if you want index funds.  It’s easy to find investment ideas for Vanguard index funds online. If you’re a DIY investor, having access to a lot of free information can make you a confident investor. 

You can open a free traditional or Roth IRA. For example, Vanguard can be the easiest way to invest like a Boglehead.

Summary

An IRA allows you to you save for retirement and only pay taxes once on your contributions. Even if you have a 401k, you can open an IRA to save even more for retirement in a tax-advantaged account.

Plus, opening an IRA at a free investing app lets you avoid paying trade fees and annual account fees.