Individual Retirement Accounts (IRAs)
When it comes to your retirement, it’s never a bad idea to maximize your savings as early as possible. By investing early and consistently, you’ll be at a huge advantage for securing a comfortable retirement.
An IRA is part of any solid retirement savings strategy. Though you may be contributing to a retirement plan at work, having an IRA allows you another tax-efficient method of saving for retirement. And if you have multiple retirement accounts, you can consolidate all your retirement assets into an IRA.
What is an IRA?
An Individual Retirement Account, or IRA, is a tax-advantaged retirement savings account. Unlike employer-sponsored accounts like 401(k)s, IRAs are opened by individual investors.
Upon opening an IRA, you can invest your funds into stocks, exchange-traded funds, and mutual funds. You can also use your IRA to supplement any of your employer-sponsored retirement plans, which unlocks a potentially wider range of investment options.
There are various types of IRAs including Traditional, Roth, SEP, SIMPLE, and Rollover. Each has different requirements, conditions, and unique benefits.
Depending on the type of IRA, you benefit from one of two huge tax perks:
- Tax-deferred growth so you can postpone taxes until you withdraw your money from your account, and
- Tax-free growth so you won’t owe taxes on your investment earnings at all
In exchange for these tax benefits, there are certain restrictions, such as contribution limits and an early withdrawal penalty.
An IRA can include savings from several different sources. In addition to contributing directly, you can also roll over contributions from 401(k)s and other employer-sponsored retirement plans.
Whether you choose a Traditional, Roth, SEP, or SIMPLE IRA, the tax benefits allow your savings to compound at a much faster rate than in a taxable account. If you need to save for living expenses, travel plans, and passion projects in retirement, having an IRA is a no-brainer.
JUST ONE CONVERSATION CAN CHANGE YOUR LIFE FOR THE BETTER
- I've heard of a Rollover IRA. What's that?
- How Does an IRA Work?
- Individual Taxpayers: Traditional vs. Roth IRA
- Small Business Owners and Self-Employed Individuals: SEP vs. SIMPLE IRA
- Interested in opening an IRA?
I’ve heard of a Rollover IRA. What’s that?
The Rollover IRA is an account that allows you to move funds from your old employer-sponsored retirement plan into an IRA. Generally, folks will open a Rollover IRA after leaving a job with an employer-sponsored plan, such as a 401(k) or 403(b).
A Rollover IRA generally has greater flexibility and lower fees than a 401(k). You aren’t subjected to taxes or withdrawal penalties at the time of transfer, and funds can continue to grow with tax-favorable treatment. It’s best for those who want to consolidate former employer plans and gain access to more investment options.
How Does an IRA Work?
Investments held in IRAs can encompass a range of financial products, including stocks, bonds, ETFs, and mutual funds.
Because IRAs are intended to help you save for retirement, you’ll pay an early-withdrawal penalty of 10 percent if you withdraw from your accounts before age 59½. Depending on the type of IRA you have, you may also be required to pay income tax on your early withdrawal.
As an individual taxpayer, you can establish a Traditional or Roth IRA.
Employers can open SEP IRAs and SIMPLE IRAs.
Individual Taxpayers: Traditional vs. Roth IRA
*You may contribute earned income which includes wages, salaries, tips, bonuses, commissions, and self-employment income. It doesn’t include alimony, child support, rental property income, interest and dividends from investments, pay you received from an inmate in a penal institution, retirement income, Social Security, or unemployment benefits.
Small Business Owners and Self-Employed Individuals: SEP vs. SIMPLE IRA
Ready to explore your retirement options? I’ll personally walk you through the process.
Benefits of an IRA
Supplement your current savings
Open up your investment options
Manage your tax bill
Enjoy greater control
Streamline your retirement accounts
Most individual investors open IRAs with brokers. However, when it comes to financial matters, it’s safest to go with a Registered Investment Advisor. Why? You might be surprised to learn that not all banks, brokers, or financial advisors are required to act in the best interest of their client.
Types of IRAs
Traditional and Roth IRAs are two of the most widely used individual retirement savings vehicles. The lesser-known SEP and SIMPLE IRAs offer tax-saving, money-growing benefits for employers. You can also take advantage of a Rollover IRA to consolidate all your retirement assets and access better investment options.
There are two kinds of Traditional IRAs: deductible and nondeductible. Whether you qualify for a full or partial tax deduction depends mostly on your income and whether you have access to an employer-sponsored retirement account, such as a 401(k). In general, if you (and your spouse) don’t have a retirement plan at work, you’ll be able to take a full deduction for your contribution.
You do defer taxes over the life of your IRA, but at a certain point Uncle Sam wants his cut. You’ll pay income taxes on your distribution. However, if you think you’ll be in a lower tax bracket than during your earning years, you’ll benefit from paying a lower tax rate on your IRA distributions.
For 2021, the individual contribution limit is $6,000 per year. If you are 50 or older, you can contribute up to $7,000 annually thanks to catch-up contributions. Excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA.
Per the 2019 SECURE Act, by age 72, you must begin taking required minimum distributions (RMDs) based on your account size and life expectancy. Failure to do so may result in a tax penalty amounting to 50% of the amount of the RMD.
A Roth IRA allows for tax-free savings and distributions. Your contributions aren’t tax-deductible, but in return for funding your Roth with after-tax dollars, your investments grow tax-free. When you withdraw at retirement, you get to keep all your investment gains.
You can have a Roth IRA even if you’re covered by a retirement plan at work. And you can contribute to a Roth IRA as long as you have eligible earned income, no matter your age.
The Roth comes with some flexibility regarding withdrawals. You can take out your contributions anytime, but you can’t withdraw earnings without penalty for five years—unless you have a qualified exception, such as a first-time home purchase.
Roth IRAs don’t have RMDs. If you don’t need to withdraw money, you don’t have to take anything out of your account. This feature means that Roth IRAs are ideal wealth-transfer vehicles.
For 2020, the individual contribution limit limit is the same as for traditional IRAs, or $6,000 per year. Again, if you are 50 or older, you can contribute up to $7,000 annually using catch-up contributions.
However, single filers making more than $139,000 (and joint filers making above $206,000) are restricted from contributing to a Roth IRA. To circumvent the income limitation, you can use a Backdoor Roth.
Backdoor Roth IRA
A Backdoor Roth is an alternative way to take advantage of Roth benefits if you exceed the income limits. In short, you can open a Traditional IRA and convert it to a Roth IRA.
It’s better if your Traditional IRA accounts consist entirely of nondeductible contributions. (If not, you’ll need to return that tax deduction.)
When it comes time to file your tax return, be prepared to pay income tax on the money you converted to a Roth. And if the money in your Traditional IRA has accrued investment gains, you’ll also owe taxes on those gains.
Types of Transfers
The conversion must take place one of three ways:
A rollover. You receive the money from your Traditional IRA, then deposit it into your Roth IRA within 60 days.
A trustee-to-trustee transfer. The IRA provider sends the money directly to your Roth IRA provider.
A “same trustee transfer.” Your money goes from the IRA to the Roth at the same financial institution.
The pro rata rule
The IRS permits Traditional IRAs to roll over into Roth IRAs on a pro rata, or proportionate allocation, basis.
When determining your tax bill on a conversion from Traditional to Roth, the IRS will assess all your Traditional IRAs together.
Let’s say that all of your Traditional IRAs consist of 85% pre-tax funds and 15% after-tax funds; that will become the proportion of your money that is taxable upon conversion. The IRS applies the pro rata rule to your total IRA balance not at the time of conversion, but rather at year-end.
A Simplified Employee Pension, or SEP IRA, is a type of group retirement plan. Employers can establish SEP IRA plans, then make contributions to a Traditional IRA set up within the SEP IRA.
SEP IRA plans are popular among small business owners and self-employed individuals because they allow for higher contribution limits than Traditional and Roth IRAs. In general, employees can’t contribute to a SEP, and you’ll face a premature withdrawal tax penalty of 10%.
In most other aspects, SEP IRA rules are similar to those of Traditional IRAs. Your contributions are made with pre-tax dollars, your withdrawals are taxed as ordinary income, and early distributions are penalized.
A Savings Incentive Match Plan for Employees, or SIMPLE IRA, is another type of group retirement plan. Unlike SEP IRAs, SIMPLE IRAs allow you to contribute pre-tax dollars with matching contributions from your employer. Your contributions are tax-deductible, which could potentially push you into a lower tax bracket.
In 2020, you can contribute up to $13,500. If you’re over age 50, your catch-up limit is $3,000.
A SIMPLE IRA also follows the same taxation rules for withdrawals as a Traditional IRA. Distributions are subject to ordinary income tax, and there are early-withdrawal penalties.
A Rollover refers to the transfer of money from one retirement savings vehicle to another. When done correctly, a Rollover can safeguard your retirement funds against tax withholdings.
You might want to make a Rollover for any number of reasons. Perhaps you want to switch investments. Maybe you’ve received death benefits from your spouse’s retirement plan. Or maybe your employment situation has changed. In many cases, a Rollover IRA is the best way to handle old IRAs and 401(k)s.
Why open a Rollover IRA?
- Leave your plan as is.
This isn’t ideal.
You won’t be able to easily contact HR for questions or concerns, and you may be charged higher 401(k) fees as an ex-employee.
- Cash out your IRA.
This is an even worse option. Why?
You’ll have to cough up a 10 percent early withdrawal fee on top of ordinary income taxes on the amount distributed.
That translates to 40 percent wiped out of your company-sponsored nest egg.
- Do an IRA Rollover.
That leaves the last choice: you can roll over either into your current employer’s retirement plan or into an IRA.
Rolling into an IRA is generally the better option because unlike a 401(k), which can have fewer investment options and higher administrative fees, an IRA gives you a wide variety of investment options and comparatively lower fees.
1. Direct rollover
2. Trustee-to-trustee transfer
3. 60-day rollover
Does your plan qualify for an IRA Rollover?
- Traditional IRA
- Employer’s qualified retirement plan for employees
- Section 457(b) eligible governmental plan
- Section 403(b) plan
- Roth IRA (very limited)
- Designated Roth account within a plan (also limited)
Pros and cons of an IRA rollover
Which IRA is Best For Me?
- Your employment status
- Your income
- Your workplace benefits
- How much you want to contribute
- Whether you plan to withdraw before your designated retirement age
- Traditional IRA. You can deduct your contributions as they’re going into your account, but you’ll have to pay taxes on distributions in retirement. If you do a 401(k) Rollover, you won’t pay any taxes on the rolled-over amount until retirement.
- Roth IRA. You make contributions with after-tax money, so your withdrawals and gains are tax-free after age 59½. You’ll have to pay taxes on the rolled amount, unless you’re rolling over to a Roth 401(k).
Stick with a Traditional IRA if you need to use cash from the Rollover to foot the tax bill today. A Roth IRA will only open you up to more tax complications.
Take charge of your retirement outcomes
Get in touch today to learn about whether a Rollover IRA is right for you!
BOOK YOUR COMPLIMENTARY CONSULTATION
Get in touch today to start the conversation!
Season 2, Episode 25: Personal Finance Coaching: UFC Fighters to Professional Blackjack with Chris Hanna
Welcome to Season 2, Episode 25 of Meet the Expert® with Elliot Kallen! In this episode, Elliot Kallen brings on Chris Hanna, a Financial...
Welcome to Season 2, Episode 24 of Meet the Expert® with Elliot Kallen! In this episode, Elliot Kallen brings on Melissa Houston, a contributor for...
Welcome to Season 2, Episode 23 of Meet the Expert® with Elliot Kallen! In this episode, Elliot Kallen brings on Trey Banton, a regional Vice...
once per month straight to your inbox!