Retirement
02.05.2024 By Carolyn Pemberton

Saving Outside of Work Through an Individual Retirement Account (IRA)

IRA, Roth IRA, SEP-IRA, 401(K), 403(B) – the alphabet soup of retirement saving plan options can be confusing. The main difference is that 401(k) and 401(B) plans are offered through an employer and an IRA – Individual Retirement Account – is an option open to anyone who earns income.

IRA, Roth IRA, SEP-IRA, 401(K), 403(B) – the alphabet soup of retirement saving plan options can be confusing. The main difference is that 401(k) and 401(B) plans are offered through an employer and an IRA – Individual Retirement Account – is an option open to anyone who earns income.

If you’re wondering how an IRA works and whether or not it’s an option for you to consider, we’re here to help you make that decision by providing some background information.

An IRA is a tax-advantaged investment account that helps you save for retirement. The advantage of an IRA is that the money you invest grows either tax-free or tax-deferred, depending on the type of IRA you have.

WHO QUALIFIES TO MAKE IRA CONTRIBUTIONS?

Anyone earning an income is eligible to open an IRA to save for retirement. This also includes employees with a 401(k) or 403(b) account through work, a non-working spouse whose partner is earning an income, or even a minor making their own money. So yes, your high school age students can have IRA, which is a great way to help them get in the early habit of saving for those long term goals.

An IRA can be opened through banks, credit unions, online brokers, or other financial services providers. The funds deposited can be invested in stocks, bonds, exchange-traded funds or other assets.

How your account balance grows over time depends on how much money you contribute and the types of investments you choose. There are several types of IRAs - traditional IRA, Roth IRA, SEP IRA and SIMPLE IRA.

Even if you choose to open more than one IRA you will be limited to a total annual contribution amount established by the Internal Revenue Service (IRS). And because the funds are intended to be used for retirement, you may face a 10% penalty and a tax bill if you withdraw money before age 59 1/2, unless you qualify for an exception.

So, let’s cover a few other basics of IRAs:

Traditional IRA:

Contributions to traditional IRAs are often tax-deductible and the money in the account grows tax deferred. You won’t have to pay taxes on any of the earnings until you withdraw money. For example, contributing $3,000 to a traditional IRA could reduce the amount of your taxable income by $3,000. However, withdrawals from traditional IRAs in retirement are taxable as ordinary income.

If you're married and you or your spouse has a retirement plan at work, the amount of your traditional IRA contribution that you can deduct is reduced, and eventually eliminated altogether, above a certain income limit. You can still make contributions, but they won’t be tax-deductible. If you and your spouse don't have retirement plans at work, then you can deduct your IRA contribution no matter how much your income is.

Check here for the most up to date IRA contribution limits.

Once you start taking money out of a traditional IRA in retirement, you will have to pay ordinary income tax on any earnings and on your-tax deductible contributions. There will not be any federal tax withheld on non-deductible contributions. Depending on where you live, you may have to pay state taxes on those withdrawals.

Roth IRA

Contributions to Roth IRAs are not tax-deductible, but withdrawals from Roth IRAs are tax-free and there are no taxes on investment gains. In other words, you won’t have to pay federal taxes, or states taxes depending on your residence, on earnings when you withdraw money, provided you meet certain requirements. You can withdraw contributions (but not earnings) early, before age 59 ½, from a Roth IRA without being subject to income tax and the penalty.

SEP-IRA and SIMPLE IRA

Generally, SEP IRAs and SIMPLE IRAs are for self-employed people and small employers with fewer than 100 employees, respectively. You can click here for additional information about SEP IRAs and here for SIMPLE IRAs.

Using an IRA

A big benefit of an IRA is that the money you invest in one grows either tax-free or tax-deferred, depending on the type of IRA you choose.  With an IRA you may also have more investment options to choose from than through an employer-provided plan. It is important to remember that there are annual contribution limits to IRAs which are lower than those allowed through an employer plan.

If you decide that an IRA is a good choice for your retirement saving plan, you may want to use the America Saves Spending and Saving Tool to help you determine how much you can save into your IRA.

Finally, as we always say at America Saves – saving automatically is the best way to save. Talk with the financial institution you’ve chosen to open an IRA with and find out how to set up automatic contributions. That way you don’t have to worry about remembering to make your regular deposits – it’s being done for you.

 

 

 

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