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What is an IRA? How to Plan Your Retirement Like a Pro

By Rebecca Lake
September 30, 2019

When it comes to planning for retirement, do you think you’re on track or do you have room for improvement? 

If you think your retirement planning efforts could use a boost, you’re not alone. 

One in three workers is less than confident about being able to enjoy a comfortable retirement, according to the Employee Benefit Research Institute. But here’s the good news: An individual retirement account (IRA) can help you step up your savings game and create financial security for the long-term. 

Read on to learn how you can plan your retirement like a pro.

What is an IRA?

Great question. 

Simply put, this is a type of investment and savings account that helps you sock money away for your retirement years, while enjoying some tax benefits. 

When you invest in an IRA, you’re typically putting your money into the stock market versus keeping it in a typical savings account or CD. For example, you might invest in stocks, mutual funds or bonds. This means your money has more of a chance to grow and increase in value over time. 

There are two general categories of IRA: traditional and Roth. With a traditional IRA, you fund your account using pre-tax dollars. A Roth IRA, on the other hand, is funded with after-tax dollars. 

There are pros and cons with both traditional and Roth IRAs. For example, you may be able to deduct the money you contribute to a traditional IRA each year. That’s a good thing if you’re in a higher tax bracket, since deductions reduce your taxable income for the year. 

A Roth IRA doesn’t offer that kind of tax break, but you do get another benefit on the back-end when you start making withdrawals. We’ll explain exactly how that works in just a minute. 

How does an IRA work and why should you contribute?

The basic idea behind an IRA is that you put money into it during your working years. Your money can then grow on a tax-advantaged basis. You can then start tapping into your IRA money to pay for retirement or other costs starting at age 59 ½. 

Compounding interest is the main reason to start saving and investing as early as possible. Compound interest means interest you earn on your interest.

Here’s a quick example of how powerful this can be for your retirement outlook. Say you open an IRA at age 25 and contribute $5,000 a year to it. If you earn a seven percent average annual return every year for the next 40 years, you’d have almost $1.1 million set aside for retirement. Your actual contributions would be $200,000; the rest would be compounded growth. Pretty sweet, right?

If you’re saving in a traditional IRA, you’d have to pay regular income tax on that growth once you start making withdrawals during retirement. With a Roth IRA, however, qualified withdrawals are 100% tax-free since you funded your account with after-tax dollars. 

Another benefit to having a traditional or Roth IRA is that you can also have an employer-sponsored plan, also known as a 401(k) plan, at the same time. So, if you’re saving money in your 401(k) plan at work, you can build up your savings cushion even more with an IRA. 

Roth vs. Traditional IRA: Which one is right for you?

There are a few ways in which Roth and traditional IRAs are the same:

  • Both offer tax breaks
  • Annual contribution limits are identical ($6,000 as of 2019, plus an additional catch-up contribution of $1,000 if you’re 50 or older)
  • You can invest in a wide variety of securities

But there are also some key differences between Roth and traditional IRAs. 

Roth IRA

Here are some of the main benefits of a Roth IRA:

  • Qualified withdrawals are tax-free in retirement
  • No minimum distributions are required
  • Original contributions can be withdrawn tax- and penalty-free

We’ve already discussed how qualified withdrawals from a Roth IRA (meaning those beginning at age 59 ½ or later) are tax-free. Plus, with no minimum distributions, your money can continue growing in your account indefinitely. 

With a traditional IRA, you’re required to take money from your account every year starting at age 70 ½. If you don’t do this, the IRS can hit you with a steep tax penalty. With a Roth IRA, however, you don’t have to tap into your account at age 70 ½. In fact, as long as you have earned income for the year, you can keep making new contributions to it. 

Another benefit of Roth IRAs is that you can always withdraw your original contributions without paying income tax or a tax penalty on the money. This means that if you need money to buy a home or you want to buy a car, for example, you can take out your original Roth contributions without a tax bite. 

On the con side, there is one important thing to know: Not everyone can contribute to a Roth IRA. 

For 2019, you’re eligible to make a full contribution to a Roth IRA if:

  • You have earned income
  • You file your taxes as single, head of household or married filing separately and your modified adjusted gross income is less than $122,000
  • You’re married, file a joint return and your combined MAGI is less than $193,000
  • You’re married, file separately but still live together and your MAGI is less than $10,000

The IRS allows you to make a partial contribution to a Roth above those income limits but eventually, your contribution amount dwindles to zero the more you earn. 

Traditional IRA

Traditional IRAs have their own advantages:

  • Contributions may be eligible for a tax deduction
  • You can withdraw up to $10,000 for the purchase of a first home with no early withdrawal tax penalty
  • Contributions grow on a tax-deferred basis

You will pay ordinary income tax on money you withdraw from a traditional IRA beginning at age 59 ½. You may also pay a 10% early withdrawal penalty for distributions taken from your account before that age. The IRS does, however, allow a few exceptions to the rule. For example, you can avoid the 10% penalty (but not regular income tax) if you take an early withdrawal because:

  • You pass away and your beneficiaries are making an early withdrawal
  • The money is being used for qualified higher education expenses
  • You’re withdrawing up to $10,000 for the purchase of a first home
  • You need the money to pay health insurance premiums while you’re unemployed

The IRS doesn’t place any income limits on who can contribute to a traditional IRA. You just need to have earned income for the year. But, whether you can deduct your full contribution depends on your filing status and whether you’re covered by a retirement plan at work. This list highlights when traditional IRA contributions are and aren’t deductible for 2019:

If You ARE Covered by a Plan at Work:

You can deduct the full amount of your contribution if:

– You file single or head of household and your MAGI is $64,000 or less

– You’re married filing jointly or a qualifying widower and your MAGI is $103,000 or less

You can take a partial deduction if you’re married filing separately and your MAGI is $10,000 or less

If You ARE NOT Covered by a Plan at Work:

You can deduct the full amount of your contribution if:

– You file single, head of household or qualifying widower OR if you’re married filing or separately and your spouse is also not covered by a plan at work

You can deduct the full amount of your contribution if:

-You’re married filing jointly, your spouse is covered by a plan at work and your MAGI is $193,000 or less

–  You’re married filing separately, your spouse is covered by a plan at work and your MAGI is $10,000 or less

One potential downside to a traditional IRA is the required minimum distribution rule. Once you start taking RMDs, you can’t make new contributions to your account. And if you don’t take the distributions, the tax penalty is equal to 50% of the amount you were required to withdraw.

IRA vs. 401(k)

With a traditional 401(k), or employer-sponsored retirement plan, you fund your account with pre-tax dollars and pay tax on distributions in retirement. 

Yet, there are some primary differences between an IRA and a 401(k):

  • 401(k) plans offer higher annual contribution limits ($19,000 for 2019, or $25,000 if you’re 50 or older)
  • Your employer can make matching contributions to your plan 
  • Your contributions can be taken out of your paycheck automatically so you don’t have to figure out what to contribute once your direct deposit hits your account
  • A 401(k) plan may charge higher administrative or management fees compared to the brokerage that holds your IRA
  • Your 401(k) plan may offer a different selection of investments compared to an IRA
  • Your plan may allow for loans, which wouldn’t automatically trigger a 10% early withdrawal penalty

A 401(k) can offer you more room to save, thanks to its higher annual contribution limit. And matching contributions from your employer are essentially free money you can use to grow your retirement cushion. 

How much money should I contribute to an IRA?

Whether you go with a traditional IRA vs. Roth IRA, the contribution limits are the same. Keep in mind that these limits can adjust from year to year to account for inflation and cost of living increases. 

In terms of how much you personally should contribute to an IRA, it depends on what type of IRA you want to open, whether you’re covered by a retirement plan at work and how much money you have to save in an IRA. If you’re looking for a specific dollar amount, consider:

  • What, if anything, you’re putting into a workplace plan
  • How much room you have left in your budget to save
  • Your other financial goals

So, say you have $1,000 a month to work with. If you also have some student loans you’re trying to pay down, you could split it in half and put $500 a month into your IRA. That would put you on track to meet the full $6,000 contribution limit. 

But, if you have less money to save and apply to debt, you might take a different route. For example, if your student loans are at a lower rate, then you might put $300 in your IRA and the rest toward your debt. On the other hand, if you have a credit card balance with a double-digit APR, it might make more sense to throw as much cash as possible at the debt to wipe it out and then contribute $100 a month to your IRA. 

Remember, the key to saving for retirement is consistency and getting an early start. Every month you delay saving can make it harder to play catch up later. 

Need a little nudge with saving more money consistently? Consider setting up an automatic transfer from your Chime account to your savings account every payday. This way, when you’re ready to contribute to your IRA, you’ll have the money at the ready. 

When can I withdraw money from my IRA?

Technically, you can take money from an IRA at any time. Just be aware of the tax penalties. And remember: The goal of these accounts is to save for retirement. 

If you think you’ll need to withdraw money from a traditional IRA before you retire, check to see if your withdrawal reason qualifies for an exception. Also, if you’re taking money early from a Roth IRA, consider sticking with withdrawals of original contributions only so there are no tax implications. 

The Upshot: 5 Reasons to Open an IRA Now

If you’re on the fence about opening an IRA to plan for retirement, there are plenty of great reasons to go ahead:

  • The sooner you invest, the more time your money has to grow and compound
  • Opening an IRA can offer tax benefits that you wouldn’t get with a regular savings account
  • Brokerage accounts can offer plenty of variety when it comes to investment options, so you can build a portfolio that fits your needs and goals
  • You can use an IRA to grow retirement wealth alongside your workplace plan 
  • An IRA is an easy way to start saving for the future if you don’t have a retirement plan at work 

Investing in a traditional IRA or a Roth account may seem a little overwhelming at first but this guide is designed to break it all down for you. 

Here’s something else to keep in mind: Before opening an IRA, take time to compare account options and fees at different brokerages. The more you know about IRAs, the more confidently you’ll be able to invest for the future. 

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