An IRA (Individual Retirement Account) is a tax-advantaged account set up by investors that allows them to save money for retirement. An IRA allows tax-free growth of funds and also permits tax-free withdrawals (subject to some conditions.)
IRAs are held by custodians, which typically include banks, trust companies, brokerage companies, federally insured credit unions, or any other institution authorized by the Internal Revenue Service (IRS) to act as an IRA custodian. Custodians take your funds and invest them across a range of financial products of your choice. Investment choices include stocks, bonds, mutual funds, and ETFs (Exchange-traded funds).
What are the Different Types of IRAs?
There are four types of IRAs:
1. Traditional IRAs
In a traditional IRA, you make pre-tax contributions, so you do not pay income tax on the money you put into the account. Your funds potentially grow tax-free in this account. When you withdraw the money after 59.5 years or later, you pay taxes on the money withdrawn. Since many retirees fall in a lower tax bracket during retirement, this option becomes attractive as a retirement investment strategy.
2. Roth IRAs
In a ROTH IRA, you contribute after-tax dollars, and your funds grow tax-free in this account. Also, at the time of withdrawal, you are not liable to pay any taxes (specific to some conditions) as you have already paid them at the time of contributing. A Roth IRA plan is recommended if you expect to be in a higher tax bracket during retirement or the later years of your life.
3. SEP (Simplified Employee Pension) IRAs
These accounts are useful retirement savings vehicles for small-business owners, freelancers, self-employed people, etc. The contributions made to SEP IRA offer tax deductions; while the savings grow tax-deferred, the withdrawals during retirement are taxed as per ordinary income tax rates.
4. SIMPLE IRAs
SIMPLE IRAs are retirement savings accounts for companies with 100 or less employees. SIMPLE IRA contributions reduce taxable annual income and allow your money to grow tax-free in retirement plans until withdrawn. Upon withdrawal, the income tax rates apply on distributions.
SEP and SIMPLE are not as widely popular and beneficial as the traditional and Roth IRAs.
What is the Income Eligibility Criteria for an IRA and What are the Contribution Limits?
The IRS limits IRA contributions and also implies specific income eligibility restrictions on an IRA to deter high-income earners. The yearly contribution cap for the years 2019, 2020, and 2021 is $6,000. However, if you are 50 years old or above, the contribution cap for all three years is $7,000 each. This is also known as a ‘catch-up contribution’ for those nearing retirement. These limits apply irrespective of the kind of IRA plan you hold.
Furthermore, you can only make contributions from your earned income towards an IRA. Earned income is inclusive of wages, salaries, self-employment profits, etc., and is exclusive of Social Security benefits or similar help from the government.
In 2021, the income limit to qualify for a Roth IRA is $140,000 of the modified adjusted gross income (MAGI) for single filers and $208,000 for joint filers. This limit is generally amended annually taking inflation into consideration.
For SEP IRAs, the annual contribution was $57,000 in 2020 and is $58,000 in 2021. For SIMPLE IRAs, you can contribute up to $13,500 in 2021. A catch-up contribution of an additional $3,000 is permitted in SIMPLE IRAs if you are 50 years and older.
What are the Benefits of an IRA?
1. Accessible and easy to set-up
The eligibility criteria and income limitations for an IRA are considerably flexible. Hence, most people easily qualify to open and save with a traditional IRA. Moreover, there is no age limit for opening a Roth IRA. However, the MAGI might restrict the contributions annually. You can easily open an IRA with an authorized financial institution within minutes. You can also manage your investments on your own, choose an expert, or use the automatic monitoring and rebalancing feature to invest your funds.
2. Tax advantages
Depending on the type of IRA, you can avail significant tax advantages. In a traditional IRA, you can lower your existing taxable income by deferring taxes on contributions from the present, as well as enjoy tax-free growth of your savings. In the case of a Roth IRA, you pay taxes on contributions now to avoid taxes eating into your money when you have minimal or no income in your retirement years. Additionally, you get tax-free earnings on funds, along with tax-exempted withdrawals, subject to specific conditions.
3. Exclusive ownership
In an IRA, you are not merely a participant like in a 401(k) plan. You are also the sole owner of your IRA plan. In a 401(k) account, the employer can change the plan or limit your investment options without your consent, which is not possible in an IRA. Additionally, when you quit your job, you also lose the ability to contribute to the existing 401(k) plan. An IRA, on the other hand, is yours to keep. Your access, investment range, and other features remain unchanged, irrespective of your employment or any other factor. You can also customize your IRA as per your risk profile and retirement goals.
To sum it up
You can rollover your existing qualified retirement savings accounts like a 401(k), 403(b), etc., into an IRA, subject to some conditions. You can choose to make the transfer into a traditional IRA or a Roth IRA. To make an informed decision about rolling your 401(k) into an IRA, it is best to take a look at the benefits and drawbacks of the conversion.