- IRA stands for Individual Retirement Account. Unlike a 401(k) or 403(b) which are linked to your employer, an IRA is connected to you and does not involve your employer.
- People typically open an IRA to transfer and consolidate employer-sponsored retirement accounts, such as a 401(k), when they leave a job. IRAs also offer tax advantages.
- There are two main types of IRAs, Traditional IRAs (covered here) and Roth IRAs. The key difference is that a traditional IRA takes pre-tax contributions, while a Roth IRA requires post-tax contributions.
- Overall, IRAs are a powerful retirement savings tool for people who don’t have access to a workplace account or for those who are transferring an old 401(k) to their own account.
Did you know that more than one in three American households own an Individual Retirement Account (IRA)? Put together, Americans have saved over $9.7 trillion in IRAs alone. That’s not surprising, since IRAs offer great tax advantages for your retirement savings. You may be familiar with a 401(k) through your employer — like a 401(k), an IRA is a retirement account, but the key difference is you can open and maintain an IRA on your own without an employer.
That covers the fundamentals, so the rest of this guide will help answer these common questions:
- What is an IRA? How does an IRA work?
- How do I choose the best IRA for me?
- How do I fund my account and what are the IRA contribution rules?
- When can I withdraw money from my IRA?
- What taxes will I pay on my IRA withdrawals?
- Can my spouse, children, or other relations inherit my IRA?
An Individual Retirement Account (IRA) is one of the most popular retirement savings tools. Opening an IRA is simple – most people create an IRA when they decide to transfer their employer-sponsored 401(k) to their own IRA. This is called a rollover.
IRAs work similarly to other retirement accounts. Once you fund your account, you can make IRA investments in stocks, bonds, and other assets. IRA plans typically offer thousands of investment choices, including individual stocks, ETFs, mutual funds, and even alternative assets like cryptocurrency. This allows you to optimize your IRA investments for aggressive growth, balanced growth, or cash preservation depending on your age and retirement plans. On the other hand, the average 401(k) only offers between 8 and 12 investment choices, with some offering fewer – these choices tend to be mutual funds or stable value funds. This difference is important because you’ll want to have choices for you to invest your portfolio based on your goals.
You have many choices when it comes to selecting an IRA provider. Some common factors to consider are:
- Do you want an automated IRA (where investment decisions are made for you) or a self-directed IRA (where you can make your own investment decisions)?
- Ease of use – Some IRA providers have easier user interfaces than others. If this is important to you, compare your options to see which you prefer.
Annual fees – Automated IRAs typically charge an annual management fee as a percentage of your total assets (usually between 0-0.4%). For example, if your automated IRA charges 0.25% and you have a $10,000 account, you’ll pay $25 per year to the IRA provider. Self-directed accounts, on the other hand, may not charge any fees or a flat monthly fee (e.g. $10 a month). Remember, you may pay additional fees based on the mutual funds or ETFs you choose based on their expense ratios.
You can fund your IRA in two ways:
- Roll over your employer-sponsored 401(k): When you transfer your 401(k) to an IRA, you will typically have a better view of your overall retirement savings, and find it easier to manage your investments. You can even roll over an old 401(k) that you have not used in years.
- Directly contribute to your IRA out of your yearly income: Each year, you can contribute up to $6,000 if you are 49 and under, and $7,000 if you are 50 and over. Generally, IRA contributions are tax-deductible. However, the amount that you can deduct depends on your income, so make sure you review the yearly contribution limits and tax deduction rules carefully.
Technically, you can withdraw money from your Traditional IRA anytime. However, there may be tax consequences for withdrawing money early. The standard age at which you can begin to withdraw without a penalty is 59 ½. If you withdraw money before you are 59.5, you will likely have to pay a 10% penalty on top of normal income taxes.
There are exceptions that allow you to withdraw without a penalty before age 59.5, including disability costs, higher education tuition, and first-time home-buying costs. Since these rules can be complex, it’s a good idea to check with a financial advisor to make sure your withdrawal qualifies as an exception.
With IRAs, you must start withdrawing money when you turn 72 at the latest. These mandatory withdrawals are called Required Minimum Distributions (RMD).
This is different for Roth IRAs. With a Roth, you can withdraw your contributions anytime without penalties, but your earnings have the same restrictions as a Traditional IRA. In addition, there are no required withdrawals for a Roth IRA, no matter how old you are.
When you withdraw money from a traditional IRA, it will be taxed at your current income tax level because your contributions were made pre-tax. This is why a traditional IRA is considered a tax-deferred IRA – you pay taxes later, not when you contribute.
The typical person’s income tax bracket is usually lower in retirement years than during their working years; so, you’ll likely experience a tax benefit when you withdraw your savings later.
This is different for a Roth IRA. Contributions to Roth IRA are made post-tax, which means your withdrawals are tax-free. This can be a major boost to your retirement savings since your investment gains are effectively untaxed, especially if you expect to be in a higher tax bracket when you ultimately withdraw from your account.
Traditional IRAs are a great option when planning for your retirement, but you should still do your homework before deciding to open and fund your account. There are yearly contribution limits, withdrawal rules, and tax advantages to understand in advance. Once you’re all set up, you can rest easy knowing you’re on your way to achieving your financial goals.
Not sure where your old 401k is? We can help with that.
Don’t lose track of your money. We’ll help you choose a new retirement account, and handle the paperwork, for free.