What is an IRA?
IRAs, or Individual Retirement Accounts, are investment accounts that allow you to save for retirement in a tax-efficient way. You can also use an IRA to transfer, or “rollover” money from other retirement accounts, like a 401(k), tax-free.
Similar to 401(k) accounts, IRAs allow you to invest your savings in stocks, bonds, and other assets. They have similar tax-advantages where a certain amount of money can be contributed before taxes and then gets to grow tax-free until the time of withdrawal.
Also similar to 401(k)s, there are withdrawal restrictions: you may face a 10% penalty and pay ordinary income tax on money you withdraw before age 59 1/2, unless you qualify for an exception.
There are two main types of IRAs, Traditional and Roth, each with specific tax benefits.
How do IRAs work?
You can open an IRA at many financial institutions, like a bank, broker, or robo-advisor. If you open an IRA at a broker or robo-advisor, you’ll be able to invest in stocks, bonds and other traded assets. IRAs from banks generally offer certificates of deposit and savings accounts — this is more like a savings account and offers you a fixed rate of interest which is likely to be low in today’s environment.
- Self Directed IRAs allow individuals to manage their investments on their own at a brokerage firm like Fidelity or Schwab.. They’re typically used by more active investors who want more control over their portfolios. Most self-directed IRAs allow you to invest in a full range of stocks, exchange-traded funds (ETFs), and options. Some IRAs even allow you to invest in alternative assets like real estate or cryptocurrency.
- Automated (Robo-Advisor) IRAs set up a portfolio for you and they use technology to automatically rebalance it over time. This makes them a good fit for people who want to outsource their investing decisions or don’t feel qualified to make their own trades. To use these accounts, you’ll generally pay an annual fee that’s expressed as a percentage of your assets, known as a “management fee” or an “advisory fee”.
How do I contribute to an IRA?
While many 401(k)s require contributions to come directly from a paycheck before taxes are withheld, IRAs allow you to contribute after-tax dollars. For most providers, you can contribute online using your computer or mobile device.
Depending on the type of IRA and your annual compensation, taxpayers under 50 years old can contribute up to $6,000 a year to their IRAs (in 2020 and 2021). Those who are at least 50 years old by the end of the tax year can contribute an additional $1,000 per year, for a total of $7,000 (in 2020 and 2021).
1. Traditional IRAs
Traditional IRAs allow individuals to make contributions with money that can be deducted on your tax return. Earnings contributed to a traditional IRA can grow tax-deferred until you withdraw them in retirement. For these reasons, we call them “tax-me-later” accounts — the money usually goes in and compounds tax-free, but tax is paid on withdrawal.
Many people find themselves in a lower tax bracket when they retire than they were in pre-retirement, so the tax-deferral means the money may be taxed at a lower rate.
Contributions to traditional IRAs are often tax-deductible, meaning if you contribute $6,000 to a traditional IRA, it could reduce the amount of your taxable income by $6,000. That means if the money you contributed to a traditional IRA already had taxes withheld from it, you may be able to deduct the contribution amount from your taxable income and potentially get the tax dollars back as a refund.
The IRS limits how much money you can contribute to an IRA on a tax-free basis each year though. The contribution limit for traditional IRAs in 2020 and 2021 is $6,000 per year. People 50 and older can contribute up to $7,000 per year.
The amount of your contribution that you can deduct from your taxes, also varies. If you are covered by a 401(k) or any other employer-sponsored plan, your modified adjusted gross income (MAGI) will determine how much of your contribution you can deduct—if any.
2. Roth IRAs
Roth IRAs allow individuals to make contributions with money they’ve already paid taxes on (after-tax), and your money can grow tax-free, with tax-free withdrawals in retirement.
This means that unlike other investment or savings accounts where you pay tax on the interest or dividends, the gains from a Roth IRA are not subject to tax.
To keep it simple, think of Roth accounts as “tax-me-now” accounts — you pay taxes before putting the money in, but then you generally get to withdraw it tax-free.
The IRS limits the tax-advantages of Roth accounts to people earning below a certain amount. To use a Roth in this way, your taxable income cannot exceed $139,000 in 2020 ($140,000 in 2021) if you’re single, or $206,000 ($208,000 in 2021) if you’re married and filing jointly.
Contribution limits start at $6,000 and begin phasing out or decreasing at $124,000 and $196,000, respectively, in 2020, and $125,000 and $208,000 in 2021.
3. Rollover IRAs
Rollover IRAs are a type of traditional IRA that allow individuals to transfer money from another retirement account. That transfer process is known as a “rollover”. Rollovers involve moving eligible assets from a retirement account that’s connected to your employer , such as a 401(k) or 403(b), into an IRA.
Rollovers do not have contribution limits. Since these are previously saved amounts, there’s no upper limit on how much money you can transfer in a rollover transaction.
- IRAs are a great way to consolidate your retirement savings. Many people use an IRA to consolidate all their retirement assets from old 401(k)s. That’s because they’re often easier to keep track of since an IRA is directly linked to you and you can open it on your own. IRAs also tend to have a greater range of investment options.
- Some people may not have access to a workplace retirement plan like a 401(k). While 401(k)s are great ways to save money, not every employer offers one. Opening up an IRA allows those who don’t have access to a workplace account to get many of the same advantages.
- IRAs have tax advantages that general investment or savings accounts don’t. IRAs have valuable tax benefits compared to a general investment account. Savings in an IRA get to grow tax-deferred and this can have a big benefit on how much money you accumulate over time.
- IRAs allow you to invest your savings into stocks, bonds, options, and even real estate or cryptocurrency. These are often higher-returning investments than nominal interest rates provided by other savings accounts.
There are a few factors to consider when deciding on an IRA provider. Most people compare based on fees or by choosing an institution they are familiar with.
Most large financial institutions offer an IRA of some type. No matter which provider you choose, you can always change providers down the line if you change your mind. IRA-to-IRA transfers are generally easy so you’re not locked in!
To help you compare, we’ve compiled a list of popular providers in the following categories: