So What's an IRA Anyway?
Updated: Oct 5, 2020
You may have heard someone talking about investing in an IRA to help build wealth and plan for their future, and think "That sounds great, sign me up!" But not so fast, let's make sure you know what you're investing IN before you jump in. Here's everything you need to know about IRAs.
What does IRA stand for?
IRA (spoken as the acronym, and not to be confused with Cousin Ira à la Mad About You)
stands for Individual Retirement Account. It's exactly what it sounds like. An account for any qualifying individual (like you) to make contributions for retirement savings and investments. That means only one person (you) can be the owner of the account. If you are married, both you and your spouse can each have your own IRA.
How does an IRA build wealth?
The next important thing to know is that an IRA is an investment account, not an actual investment. Think of it like a bucket. Let's say there was an endless goldmine and each year, the US government gives you a bucket to fill with gold. Then let's say the government also said they would give you special tax treatment on any gold in your bucket. The value is in the gold, not the bucket.
Though the bucket alone is not valuable, without the bucket, you would have no way to carry all that tax advantaged gold you mined. That's an IRA. A place to carry your investments year over year, so that they can grow and earn you more money (i.e. build wealth), while also saving you on taxes.
Then can I contribute as much as I want whenever I want?
While there is no minimum amount required to be contributed, each year, the IRS sets a limit on the maximum amount you can contribute to your IRA "bucket". The 2020 contribution limit for an IRA is $6,000. If you are 50 or older, the IRS allows an additional $1,000, making it a maximum contribution of $7,000.
A contribution year runs from January 1st of the given year to Tax Day the following year (typically April 15th, but this year it was July 15th due to COVID-19). That's right, you typically have 15 1/2 months to make (and hopefully max out) your IRA contributions. In comparison, you only have 12 months (January 1st to December 31st) to contribute to a 401K. This is a great advantage of IRAs, because it gives you flexibility in your contributions.
You could decide to break up your contributions evenly across those 15 1/2 months, therefore allowing you to dollar cost average and make smaller monthly contributions. Or, you could wait until you do your taxes and decide if it would help you to contribute to a Traditional IRA for the tax savings. With the 2nd method, you could make a lump sum contribution (up to the annual limit) at any point before Tax Day.
What types of IRAs are there?
The next fun fact about IRAs is that there are two general types of IRAs: Traditional and Roth. Both have their advantages, and deserve their own time to shine, so we go into a deeper dive here for Traditional IRAs and here for Roth IRAs, but to summarize each:
A Traditional IRA allows you to make "pre-tax" contributions, saving you on taxes today, and then allows the contributions (investments) to grow tax free until you are ready to withdraw from the account. You would then pay taxes on the amount you withdraw, based on your income tax rate at the time of withdrawal, for both the contributions and any growth (gains).
A Roth IRA allows you to make "post-tax" contributions (taxes have already been paid via your income/payroll taxes). All contributions (investments) then grow tax free. When you are ready to withdraw from the account, you would owe no additional taxes on neither the contributions nor the growth (i.e. withdrawals are 100% tax free!).
There are other, most specific, types of IRAs such as Spousal IRAs (for individuals who do not have earned income, but who’s spouse does), SEP IRAs, SIMPLE IRAs, etc… Many of these follow the same rules as Traditional and Roth IRAs, so for the sake of simplicity, we will stick with Traditional and Roth IRAs for this article.
Can I have both a Traditional and Roth IRA?
So now you're thinking, "sounds great, sign me up for both!" And the great thing is, if you qualify for both, you can! You can have both a Traditional IRA and Roth IRA at the same time and make contributions to both.
However, you are still limited to the annual contribution limit between the two. For example, you could contribute half the annual limit to a Traditional IRA and half to a Roth. Or, maybe you want to save more in taxes this year, so you contribute $5,000 to a Traditional and the remainder to a Roth. You can split up the contributions any way you want, so long as combined they do not exceed the annual limit.
Does everyone qualify for an IRA?
So throughout the article I keep referencing "qualifying" for an IRA and you might be wondering what that means, and more importantly, do YOU qualify?
Well, we know Uncle Sam doesn't like to just give away things to everyone and anyone, especially when it comes to taxes, so before you start mining for that IRA gold, know that the IRS puts rules around who can "get a bucket". The rules are also slightly different between which type of bucket you want to fill (Traditional vs Roth).
The first thing to know is that regardless of which type of IRA you contribute to, you must have earned income (e.g. W-2 income, contractor, tips, etc…) equal to or greater than your contribution amount.
That means that if you want to contribute $6,000 to an IRA in 2020, you must have at least $6,000 in earned income reported on your 2020 tax return.
For 2020, to qualify for a Roth IRA contribution you must meet the following requirements:
For Traditional IRAs, rather than set a limit on who can contribute, the IRS sets a limit on who can receive a tax deduction from a Traditional IRA. Depending on your tax filing status, your modified adjusted gross income (MAGI) must be below a certain threshold to receive either the full or partial tax deduction. See our “So What’s a Traditional IRA” post for a detailed table on MAGI thresholds.
Note: If your income exceeds the highest MAGI threshold for a Traditional IRA, you can still make post-tax contributions. You will just not receive a tax deduction for the contribution amount.
You may be asking why someone would want to do this, and there are specific cases where this may make sense, but generally it would be because you want the benefit of tax-free growth while investing, which you do not get with a taxable brokerage account.
How do my contributions build wealth?
Something I think gets missed or assumed when talking about IRAs, or almost any retirement account actually, is that your contributions are just the money you put in the account (the "bucket"), and alone will not build wealth. Once you make the contribution, you have to invest it in something. Make sure that when you make a contribution, you are also then buying shares of an investment option. You can invest in individual stocks or bonds, ETFs, or mutual funds like a low cost index fund that follows the Total Stock Market or S&P 500. Whatever you decide to invest in, just make sure you don't leave it sitting in the settlement account earning pennies!
Is an IRA right for me?
So you've gotten through this whole article, and are now wondering how this may fit into your bigger financial picture.
IRAs are a great investment vehicle for almost anyone, because they can serve as a supplement to your overall retirement, financial independence, or wealth building strategy, which may also include other retirement accounts like an employer-sponsored 401K, 403b, and/or 457b.
However, unlike your 401K, IRAs allow you to have full control over your investment options. You can choose your preferred provider (such as Vanguard or Fidelity) and your own funds (like VTSAX, a Total Stock Market Index Fund). With IRAs, you are not tied to using whichever provider your employer selected, or the limited investment fund options that provider may have.
What if I qualify one year for my IRA, but not the next?
If you have an existing IRA in which you qualified to make contributions one year, but then did not qualify for the next, you can still keep that IRA open and allow it to continue growing and/or move investments around within the account. You just would not be able to make any new contributions until you qualify again.
When can I access the money in an IRA?
So we've talked about contributing to IRAs, but then how do you take the money out? Again, this can be a much bigger topic depending on your financial goals, personal situation, and withdrawal strategy, but to summarize the most simple withdrawal strategy:
Contributions to either a Traditional or Roth IRA can be withdrawn, without penalty, starting at age 59 1/2. For a Traditional IRA, that includes contributions and any growth (aka earnings from your investments), however, since no taxes were paid on the original contributions, any withdrawals will be taxed at your income tax rate at the time of withdrawal.
For a Roth IRA, since the contributions were already taxed, the withdrawal rules are slightly different. You can withdraw up to the full principle contribution amount of a Roth IRA, tax free and penalty free, at any point, regardless of age.
For example, let’s say you’re 30 and contribute $50,000 to a Roth IRA over 10 years. Over those 10 years, you earn $20,000 from investment growth making the balance $70,000. At age 40, you could take out up to $50,000 without any taxes or penalties. Any amount over that $50,000 would be penalized with a 10% early withdrawal penalty.
One other early withdrawal strategy for a Roth IRA is the “five-year rule.” This rule states that you cannot withdraw from your Roth IRA unless five years have gone by since you made your first contribution. To be exact, this process starts on Jan. 1 of the year you deposited your first contribution into your Roth IRA. Only after this half-decade will the money in your account be accessible.
So there you have it. You are now certified in IRA basics! Ok, maybe it's not an official certification, but hopefully you know more now than when you started. If you qualify for an IRA, either type, and can afford the additional contributions, we highly recommend you open one and start making those contributions. Though the rules and limits may change over time, today, an IRA is an excellent way to help you grow wealth and build the life you deserve!
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