Personal Finance 101: IRAs

What Is an IRA?
•    An IRA is a tax-advantaged retirement account that comes in two primary varieties.
•    A traditional IRA offers a tax break when you put money into it. A Roth IRA gives you tax-free withdrawals when you take money out.
•    These tools can help you build retirement savings, potentially growing them over time. 

Even if you're already saving through an employer-based account, an Individual Retirement Account (IRA) can be an integral piece of your overall retirement-savings plan. The sooner you start a retirement savings habit the bigger your future nest egg will be—a critical factor in ensuring a comfortable retirement that may last 20 to 30 years or more. An IRA can help.

The Difference Between an IRA and a 401(k)
An IRA is a tax-advantaged retirement account. It differs from a 401(k)—the other common retirement savings vehicle—primarily in that it doesn’t require participation from an employer: You can simply open an IRA on your own at any time. Here are three important details about IRAs:

1.    IRAs come in two basic types: traditional or Roth. Both offer the potential for tax-deferred growth designed to boost your retirement savings. The one that’s right for you depends on your specific circumstances. 

2.    IRAs are subject to contribution caps that are updated annually by the IRS. You can find the current year’s limits at IRS.gov.

3.    You can open an IRA at a bank, credit union, life insurance company, mutual fund company, or brokerage firm.

Key Facts About Traditional IRAs
The basic premise of a traditional IRA is to minimize taxes while you’re working and instead pay them in retirement, when many people are in a lower tax bracket. Here’s how it works:

Anyone under the age of 70½ who has earned income is eligible to open a traditional IRA. In 2019, combined annual contributions to all your traditional and Roth IRAs cannot exceed $6,000 if you’re under age 50, or $7,000 if you’re age 50 or older. If your annual income is lower than the contribution limit, then your personal contribution limit is equal to your annual income.

Most contributions are tax-deductible up to the annual contribution limit and gains are tax-deferred. That means every dollar invested in your traditional IRA is a dollar deducted from your taxable income that year. (If you or your spouse is covered by a workplace retirement plan, your contributions might not be fully deductible.) And your IRA’s earnings also won’t trigger taxes as they grow.

Once you’re in retirement—or as early as age 59½—you can take withdrawals, which are taxed as income. If you withdraw any funds before age 59½, you’ll generally owe a 10% penalty in addition to the tax. There are several exceptions that aren’t subject to the early-withdrawal penalty; learn more about all of them by visiting this IRS site. 

You don’t have to withdraw from your traditional IRA at 59½. In fact, if you’re still earning income, you may want to continue making contributions. But at age 70½, you can no longer contribute, and you must begin taking required minimum distributions annually. 

Key Facts About Roth IRAs
Unlike a traditional IRA, a Roth IRA lets you contribute after-tax money now, then make tax-free withdrawals in retirement. But that’s not the only difference. 

You can only contribute to a Roth IRA if your modified adjusted gross income (MAGI) falls below certain limits. Here are the 2019 MAGI limits:

Single filers who earn:
•    $121,999 or less can contribute up to the full contribution limit 
•    Between $122,000 and $136,999 can make partial contributions
•    $137,000 or more can’t contribute to a Roth IRA

Married couples filing jointly who earn:
•    $192,999 or less can contribute up to the full contribution limit
•    Between $193,000 and $202,999 can make partial contributions
•    $203,000 or more can’t contribute to a Roth IRA  

Your Roth IRA contributions are not deducted from your taxable income, so putting money in the account is not an effective way to lower this year’s tax bill. But because you pay those taxes upfront, you can withdraw the funds you’ve contributed at any time, with no taxes or penalties. 

You can also withdraw your investment earnings tax-free as long as you’ve reached age 59½ and have held the account for at least five years. If you don’t meet those criteria, you’ll owe taxes and penalties for withdrawing earnings. 

Because a Roth IRA puts your tax obligation upfront, it can be an appealing option if you expect to be in a higher tax bracket when you retire. Roths also offer more flexibility in retirement, because there are no required minimum distributions. This feature makes Roths appealing to people who plan to leave assets to their heirs.

Other Types of IRAs
There are a handful of other IRA types and strategies that may be useful to you:

A SEP IRA is a traditional IRA geared to small businesses or self-employed people. Contributions can far exceed the typical annual limit—up to $56,000 or 25% of the beneficiary’s compensation (whichever is less) in 2019. An employer who opens a SEP IRA for herself must open one for each eligible employee. Employers must also contribute the same percentage of compensation to employees as they contribute for themselves, though that percentage can change from year to year. Employees cannot contribute. 

Like a SEP IRA, a SIMPLE IRA is a traditional IRA designed to give small businesses with 100 or fewer employees an easy way to set up retirement plans for themselves and their employees. But there are several key differences. A SIMPLE IRA allows employees to contribute to their own accounts. (The maximum employee contribution in 2019 is $13,000.) Employers can either match employee contributions up to 3% of compensation or contribute a fixed 2% of compensation every year—whether or not the employee contributes. 

The term rollover IRA refers to any IRA—Roth or traditional—that’s funded with assets moved (“rolled over”) from a workplace retirement plan, like a 401(k). You might take this step when you switch jobs, rather than leaving the funds in your old employer’s plan. Doing so preserves your retirement savings, allowing the assets to continue to grow tax-deferred and potentially making them easier to manage in an account that’s not tied to your job. Your IRA provider can fill you in on exactly how to arrange the rollover to avoid tax consequences. 

Like a rollover IRA, a spousal IRA is not a special account type; it’s a strategy. You generally need to earn income from a job or self-employment to contribute to an IRA. A spousal IRA is the exception. Under an IRS rule for married couples filing jointly, a working spouse can contribute part of his or her earned income to an IRA for a nonworking spouse. This spousal IRA can be either a traditional or Roth, and the same deductibility and contribution limits still apply for each.

How to Make the Most of an IRA
•    Choose the right IRA for you. Both traditional and Roth IRAs offer tax advantages. A key factor to consider is the tax rate that applies to your income now and what it may be in the future. You may want to talk to a financial advisor or your tax professional to decide whether it’s better to get the tax break now or later.
•    Invest in the right assets. Your risk tolerance and time horizon should determine how you invest the assets in your IRA. Generally, the longer you have until retirement, the greater the proportion of stocks, and stock mutual funds, you’ll want to hold. 
•    Max out your contributions. The more you put into your IRA, the more you’ll get out of it. That’s especially true early in your career, when your investments have a long time to benefit from the power of compound interest.
•    Take advantage of catch-up contributions. When you turn 50, your IRA contribution limit increases. For traditional and Roth IRAs, you can contribute an extra $1,000 annually. That’s an opportunity to supercharge your savings, and you should take it if you can.  

This chart is titled "Traditional vs. Roth: Key Differences" Traditional IRAs use pre-tax dollars with some exceptions and limits, are not allowed past age 70 and a half, and you pay taxes when you take money out. Roth IRAs have income limits, use after-tax dollars, contributions can be made at any age and you pay taxes now with no taxes or penalties on withdrawals if you own the IRA at least 5 years. Source: IRS.gov.

Param Anand Singh writes about money, investing, art, and culture from his home in Henderson, New York.

Read 5 Ways it Pays to Fund Your IRA. 

Video: How IRAs Can Make Saving for Retirement Easier

This article is part of Synchrony Bank’s Personal Finance Series: Level 101. View all topics in the series here.