Are you ready to start putting money aside for your future? An Individual Retirement Account (IRA) is one of the best ways to invest your money and watch it grow. There are four types of IRAs, two for individual taxpayers and two for those who are self-employed.
An IRA is a tax-deferred savings plan that provides tax advantages. The money grows tax free in your account. Depending on the type of IRA, you can fund your account with pre-tax or post-tax dollars. Likewise, depending on the IRA, you may or may not be required to pay taxes on the money you withdraw. The amount of tax you pay is determined by your current income, so you will want to be strategic with your withdrawals to minimize this tax burden.
You won’t want to get dinged by the 10% penalty assessed if you withdraw money before age 59 and ½. This penalty is why IRAs are so successful for individuals who find it hard to save money.
An IRA is similar to a 401(k) in that they are both used for savings and provide tax advantages. The difference is that a 401(k) is an employee benefit that can only be obtained through an employer.
When Should you Open an IRA?
Open an IRA as soon as you have any earned income. Earned income must meet the definition established by the IRS. It cannot include income from interest, dividends, Social Security or unemployment benefits, or alimony or child support.
IRAs offer the opportunity to save money and have tax advantages. You can invest in a wide range of investment options, such as stocks, bonds, exchange-traded funds, and mutual funds.
Types of IRAs
There are four types of IRAs, each with its own eligibility, taxation, and withdrawal rules and penalties. Individual taxpayers can use traditional and Roth IRAs. Small-business owners and those who are self-employed can use SEP and SIMPLE IRAs.
Traditional IRAs
Traditional IRAs allow individual taxpayers to invest money now and receive a tax deduction. The money grows without being taxed until it is withdrawn. For 2021, individuals under the age of 50 can contribute $6,000 to a traditional IRA, and those over age 50 can contribute $7,000. There are exceptions.
Starting at age 72, you must start taking the required minimum deductions. These deductions are based on the size of your account and your life expectancy. If you do not take the deduction, the tax penalty may be 50% of the required distribution amount.
Tax Now or Tax Later, What’s the Difference?
At first glance, it may be hard to see the tax benefit of an IRA. This is because the benefits depend on your income and the tax bracket that income puts you in.
For example:
For the tax year 2021, a person making $60,000 per year and filing single will pay 22% in taxes. They deposit $5,000 in their IRA. The $5,000 would have been taxed at 22%, so they just saved $1,100 in taxes.
Twenty years from now, perhaps they will withdraw that $5,000. So they have had the $1,100 for twenty years and could have invested it and earned interest. And, they may be in a lower tax bracket as they have cut back on working.
Roth IRAs
Unlike traditional IRAs, where you contribute with pre-tax dollars, with Roth IRAs, you contribute using after-tax dollars, which means your contributions are not tax deductible. You do not have to pay any taxes on the money your investment earns, and you can withdraw it without incurring income tax on your withdrawals. However, there are exceptions.
Unlike traditional IRAs, there are no required minimum withdrawals. You can contribute to a Roth IRA as long as you are earning money.
The maximum you can contribute is $6,000 if you are under age 50 and $7,000 if you are over age 50.
SEP IRAs
Simplified employee pension (SEP) IRAs can be used by contractors, freelancers, and small-business owners. A SEP IRA has the same require minimum withdrawals as a traditional IRA.
For 2021, self-employed individuals can contribute up to 25% of their compensation or $58,000, whichever is less.
Business owners can establish SEP IRAs for their employees and deduct the business owner’s contributions to those accounts.
SIMPLE IRAs
Savings incentive match plan for employees (SIMPLE) IRAs are also designed for small businesses and the self-employed. Like SEP IRAs, SIMPLE IRAs follow the same withdrawal rules as traditional IRAs.
Unlike SEP IRAs, employees can contribute to SIMPLE IRAs. The employee contributions are tax deductible. The limit for SIMPLE IRAs in 2021 is $13,500 for those under age 50. For those over age 50, there is a $3,000 catch-up contribution limit.
Whether you are a small business owner or an individual taxpayer, you’ll want to maximize your contributions to individual retirement accounts. You can even contribute to multiple types as long as your contributions do not exceed the limits set by the IRS. Don’t forget to name beneficiaries for all of your IRAs.
There is no one-size-fits-all guide to investment. Working with a wealth manager can ensure you make the best financial decisions for yourself and your loved ones.
