Individual Retirement Account (IRA): Definition & Types
Retirement planning can feel like a complicated puzzle, but it doesn’t have to be. Think of it like this: an Individual Retirement Account, or IRA, is like a special piggy bank that helps you save for when you’re older and no longer want to work. This piggy bank is special because it gives you extra benefits like making your money grow faster with fewer taxes.
In this post, you’ll learn what an IRA is, the benefits and the different types of IRAs. By the end, you’ll have a clear picture of how these accounts can help you save for the future and which one might be right for you.
Ready to get started? Let’s go!
What is an Individual Retirement Account (IRA)?
An Individual Retirement Account (IRA) is a tax-advantaged savings account to help you save for retirement. The main benefit of IRAs is the tax benefits which can add up to big time to your retirement savings over time. You can contribute to IRAs in cash, stocks, bonds or other investments depending on the type of IRA.
IRA Benefits
- Tax Advantages: The biggest benefit of an IRA is the tax benefits. Depending on the type of IRA you have, you can deduct your contributions or have tax free growth on your investments.
- Flexibility: You have many investment options to choose from so you can customize your portfolio to your risk tolerance and retirement goals.
- Control: Unlike employer plans, you have total control over your IRA investments.
- Compounding: The sooner you start the more your money will grow.
Types of Individual Retirement Accounts (IRAs)
There are many types of IRAs, each with it’s own features and benefits. Knowing the differences is key to choosing the right IRA for your retirement goals.
1. Traditional IRA
A Traditional IRA is the most common type of IRA. Contributions to a Traditional IRA are tax deductible, so you can reduce your taxable income for the year you contribute. But when you withdraw in retirement it’s taxed as ordinary income.
Key Features:
- Tax Deferred Growth: Earnings grow tax deferred until withdrawn.
- Tax Deductible Contributions: Contributions are tax deductible, depending on income and other retirement plan participation.
- Required Minimum Distributions (RMDs): RMDs start at age 73.
- Contribution Limits: 2024 limit is $6,500 or $7,500 for 50+
Example:
You make $60,000 a year and contribute $5,000 to a Traditional IRA. You can subtract that $5,000 from your taxable income, so you’re only taxed on $55,000. But when you retire and withdraw the money you’ll pay taxes on it.
2. Roth IRA
A Roth IRA is different from a Traditional IRA in that you contribute after-tax dollars, but withdrawals in retirement are tax-free. This is great for those who expect to be in a higher tax bracket in retirement.
Key Features:
- Tax-Free Withdrawals: Tax-free withdrawals, including contributions and earnings.
- No RMDs: Unlike Traditional IRAs, Roth IRAs have no RMDs during the account owner’s lifetime.
- Income Limits: There are income limits to contribute to a Roth IRA. For 2024, the phase-out range for single filers is $138,000 to $153,000 and $218,000 to $228,000 for married couples filing jointly.
- Contribution Limits: Same as Traditional IRAs.
Example:
Let’s say you put $5,000 into a Roth IRA this year. You won’t get a tax deduction now, but if that investment grows to $20,000 by the time you retire you can withdraw all $20,000 tax-free.
3. SEP IRA (Simplified Employee Pension)
A SEP IRA is for self-employed individuals and small business owners. It allows for higher contribution limits than Traditional and Roth IRAs, so it’s a great option for those who want to save more for retirement.
Key Features:
- High Contribution Limits: For 2024, contributions can be the lesser of 25% of compensation or $66,000.
- Employer Contributions: Only employers can contribute to SEP IRAs and contributions are tax-deductible for the business.
- Eligibility: 21+, 3+ years with employer, earned $750 in the year
Example:
You run a small business and want to contribute 25% of your net earnings? You can do that with a SEP IRA and save more for retirement.
4. Simple IRA (Savings Incentive Match Plan for Employees)
A Simple IRA is another option for small business owners, an easy way for employers and employees to contribute to retirement savings.
Key Features:
- Employee Contributions: $15,500 in 2024, plus $3,500 catch-up for those 50 and older.
- Employer Contributions: Employer can either match up to 3% of an employee’s compensation or 2% nonelective for all eligible employees.
- Easy to Administer: Simple IRAs are easy to set up and maintain, great for small business.
Example:
You can contribute $15,500 per year, plus $3,500 catch-up if you’re 50+. Your employer can match your contributions up to 3% of your salary or 2% of your salary regardless of your contribution.
5. Self-Directed IRA
A Self-Directed IRA lets you invest in more assets beyond stocks and bonds, like real estate or private equity.
Key Features:
- Investment Flexibility: More investment choices.
- Custodian: Must be held by a custodian or trustee that specializes in self directed accounts.
- Complexity: More due diligence and understanding of IRS rules to avoid prohibited transactions and penalties.
Example:
Want to invest in rental properties? A Self-Directed IRA lets you use your retirement funds to buy real estate.
Choosing the Right IRA
Choosing the right IRA depends on several factors including your current financial situation, retirement goals and tax situation. Here are some questions to ask:
- What’s your current and future tax situation? If you think you’ll be in a higher tax bracket in retirement, a Roth IRA might be better since withdrawals are tax free.
- How much will you contribute annually? If you’re self employed or own a small business and want to contribute more than the standard IRA limits, a SEP or Simple IRA might be the way to go.
- Do you want to be hands on with your investments? If so a Self Directed IRA might be the way to go.
- What’s your income? Your eligibility to contribute to certain IRAs like the Roth IRA depends on your income.
The Bottom Line
An Individual Retirement Account (IRA) is a great way to build your future. Knowing the different types of IRAs and what they offer will help you make informed decisions to reach your retirement goals.
Start early, review often and consider talking to a financial advisor to make sure you’re making the best decisions for your Individual Retirement Account (IRA).
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