March 17, 2020
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An Individual Retirement “Arrangement” (as the IRS now refers to it) allows individuals to have their own retirement savings or investment accounts. You can implement a traditional or Roth IRA as an individual or small business through an IRS-authorized financial services firm like a broker, bank, credit union, or mutual fund company, who will set everything up and keep the necessary records for you. (There may be a small administrative fee each year for their services.) You are then responsible for managing what’s in the account.
There are two types of individual IRAs:
- Traditional IRA
- Roth IRA
and two types of IRAs for self-employed individuals or small businesses:
- SEP IRA
- SIMPLE IRA
Traditional IRAs are basic tax-deferred retirement savings accounts. They belong solely to you and are self-managed (meaning you select your own savings or investment products inside them). You contribute money up to a certain amount by simply depositing money with the institution that administers your account (bank, broker, mutual fund company, etc.) and you can do that anytime during the calendar year.
The tax benefit in an IRA is two-fold:
1. Your contributions are pre-tax (so you get to deduct the contribution from your gross income when figuring your taxes); and
2. Your assets grow tax-free until you take the money out at retirement.
The logic behind these tax advantages is that your tax rate will usually be much lower in retirement than during your working years and you’ll therefore pay less tax later than you would now. Meanwhile, your account compounds tax free.
There are limits to how much you can contribute each year and how much of the contribution you can deduct from your taxes,depending on your income and whether you (or your spouse) is also covered by a company retirement plan.
For 2020, the maximum contributions you can make each year are:
$6000 if you are under 50 years of age; and
$7000 if you are 50 or older.
(These limits apply to combined contributions for an IRA and/or a Roth-IRA.)
The Internal Revenue Service sets the rules for IRAs,including contribution limits, withdrawal limits, allowed investments, and penalties. There are links below to IRS web sites with these details. Most IRA providers will guide you according to IRS rules so that your account maintains tax compliance, but ultimately, it is your responsibility to follow the rules and file your taxes accordingly. (It’s really quite simple and your provider will supply you with the proper records to plug into your tax return.)
IRAs are available to anyone who has earned income and has not yet reached the age of 72. After that, you are required to start withdrawing. The SECURE Act just changed this rule from 70 ½ and now also allows you to keep contributing indefinitely if you are still earning income. The“earned income” qualification essentially means that your IRA contributions must come from wages or salary and cannot come from things like investment income, interest, dividends, pensions, social security, or alimony.
You can withdraw money from your IRA without any penalties once you reach 59 ½. Before that age, withdrawals are subject to a 10% penalty.Regardless of whether you withdraw before or after that age, the withdrawal will be subject to income tax.
While IRA maximum contributions are lower than 401(k)maximums, for those without an employer plan, it is still a worthwhile tax-deferred savings vehicle. You can actually contribute to both an IRA and a company plan, but in that instance, you’d be restricted on deducting your IRA contribution from taxes.
IRAs are also self-managed, and unlike a 401(k) plan from your employer, which might have around 20 or so specific mutual funds to choose from, you have greater flexibility with your IRA. IRAs set up with brokers, for example can allow you to use any one of thousands of mutual funds, exchange-traded funds, or even individual stocks.
IRAs thus give you several overall benefits, including:
- A way to save or invest for retirement on a tax-deferred basis
- A way to manage your own retirement assets
By the way… if you have a company 401(k) plan and you leave that employer, you can transfer your assets from the company plan into your own IRA and preserve the tax status.
The Roth IRA is just a variation of an individual IRA that is treated differently for tax purposes.The Roth account allows after-tax contributions (so no tax deduction up front),but then is completely tax-free forever after, even when you withdraw money after retirement. Whether a traditional IRA or a Roth-IRA is better for you depends on your current and future tax rates, so the decision is an individual one. (One way or another, Uncles Sam will tax your earnings – it is just a matter of now or later.)
The SEP (Simplified Employee Pension) IRA is a souped-up IRA for self-employed individuals and small businesses, like independent contractors. To the individual, it will look and act like a traditional IRA, except that SEP IRAs allow contributions up to 25%of compensation or $57,000, whichever is less. If it’s for a small business,then the business sets up the account. Recipients pay tax when they eventually withdraw the money. Since SEPs are essentially business IRAs, the individual cannot add to them.
The SIMPLE (Savings Incentive Match Plan for Employees) IRA is a hybrid business IRA where the contribution limits are lower than a SEP, but employees can add their own contribution. The contribution limit for 2020 is $13,500, with a catch-up limit above that of$3,000 for those over 50.
1. IRS official web site for IRA information
2. IRS official publication for IRAs
3. IRS official site for SEP IRAs
4. IRS official site for SIMPLE IRAs
5. SEC’s Compound Interest Calculator