An Individual Retirement Account (IRA) is a type of investment account that allows people to get a tax break on funds they are investing for retirement.
There are two types of IRA accounts, a traditional IRA and a Roth IRA. The main difference here is the timing of when taxes are taken out of the invested dollars.
With a traditional IRA, the taxes are typically deductible from your taxes the year you put the money into the account. With a Roth IRA you put in after-tax dollars, and the money is not taxed upon withdrawal. In order to determine which is a better account for you, it’s important to look at current tax rates versus your expected future tax rates.
If you suspect that your taxes will be lower in the future when you begin withdrawals, it is to your benefit to invest in the traditional account. However, if for some reason you believe your taxes may actually be more later in life, then investing in a Roth IRA would be more advantageous.
The amount you can put into an IRA is dependent on a couple main factors, mainly your age and the amount of money you earn.
According to the IRS, the most you can save across both traditional and Roth IRAs for 2018 is $5,500 if you under 50 years of age. If you are 50 or older, you are able to save an additional $1,500 as a catch up payment for a total of $6,500. You also cannot invest any more than your taxable income was for that year. For instance, if you taxable income was only $3,000, then that is the maximum you would be allowed to invest.
The amount you can put into an IRA begins to phase out at certain income levels. If you are single and have a workplace retirement plan such as a 401(k) your ability to contribute is phased out with an AGI between $63,000 and $73,000. For married couples filing jointly, when the spouse who makes the IRA contribution is covered by workplace retirement plan, those numbers increase to $101,000 to $121,000.
If however you are not covered by a workplace retirement plan but your spouse is covered, then these number phase outs occur with an AGI between $189,000-$199,000.
Roth IRA accounts also have applicable phase out incomes levels which are $189,000-$199,000 for married couples filing jointly, and $120,000-$135,000 for singles and heads of household.
The main benefit of an IRA, as with a 401k, is the ability to get a tax benefit. As discussed, when investing in a tradtional IRA your money is typically tax deductible in the year you make the investment. This can be especially beneficial if you expect your tax rate to be lower in retirement than during your working years, as is the case with many people.
On the other hand, a you pay taxes before putting money into a Roth IRA, but then do not have to pay taxes when you withdraw.
If you are a disciplined saver who maxes out a workplace retirement plan like a 401k, and also saves the maximum to their IRA’s, you’re going a long way to helping ensure there’s a good amount of money waiting for you when you retire.
In general there are very few drawback’s to having an IRA account. The only one to note which is similar to other retirement accounts, including a 401k, is the penalty for taking funds before the age of 59-1/2.
If you do find yourself in the positions of needing to take funds early, you will need to pay any income tax if this was a traditional IRA, along with a 10% penalty. That’s a steep price to pay, so before committing to an IRA, be sure you can cover general expenses, and have other liquid safety nets accessible with the cash flow you are generating from your job and other income streams.
There are certain circumstances that allow you to take money from an IRA without incurring a penalty. Check out this list of 11 ways to avoid the IRA early withdrawal penalty.
At the end of the day, an IRA is a solid way to invest money that you have earmarked for retirement. Before making the investments, be sure you understand the tax implications, and which type of IRA is best for you to ensure you maximize the potential tax benefits.
Also be sure you have thought through your entire financial plan, and that you have the extra funds available to invest for the long haul, since early withdrawal often comes with penalties you want to avoid.