Why IRAs are Important: The Basics
Recently, I encountered a person who did not know what an IRA was. I was working with a colleague who is about 55 years old. She is someone I met 11 years ago when I first entered my career. Though she is mildly strange (aren’t we all), I’ve always liked her. Our assignment was rather slow, and we got to chatting.
Throughout our conversation she said multiple times, “Now, if I could only stop spending money, I might hopefully retire someday!” (I swear I wasn’t talking about money, she kept bringing it up).
She didn’t mean retire early, or retire within the next few years. She meant: retire at all.
This took my breath away.
I’ve read the stats about many older Americans not having enough money—or any money—saved for retirement and somehow it has always seemed unbelievable. And yet, here she was, in the flesh.
She has no clue I have this blog, or that I am all about saving money. That I set my goal each year to max out my IRA and my 401(k). That mid-way through this year I got access to a 457 account, and though I may not be able to max it out, I’ll get as damn close as I can.
She was just talking. So I talked with her. After asking a few questions, I realized she didn’t know what an IRA was—at all. Since she’s mostly freelance (like me), she assumed all her retirement options rested on having an employer. As she didn’t have one of those, she tried to save money on her own in a savings account. All that potential growth, nonexistent.
I shared with her what I knew, and in turn, am inspired to write this post.
What Is An IRA?
An Individual Retirement Account (IRA) is a tax advantaged retirement account (either tax-deferred, or with tax-free growth). It is not through your employer, and as of 2019, the maximum contribution is $6,000. You can set this up through a bank of your choice, and contribute to this on your own. However, the contributions must be with earned income.
If you do not have access to a retirement account through your employer, consider looking into opening an IRA. This is not a defined-contribution plan: you can contribute money to this account throughout the year, in any amount, whenever you like, as long as the total contributed for the year doesn’t exceed the maximum.
We bank with Schwab, so they are our preferred choice for our investment accounts (including retirement). Schwab, Vanguard, and Fidelity are notorious for offering access to low-cost index funds.
If you are willing to have your IRA account open at a different institution than where you bank, it may be worthwhile to look into opening an IRA at an institution that specifically offers lower cost (fee) options. However, if it is more convenient for you to open an account with whatever institution you already bank with—hell, whatever it takes to get you to open an account and get an IRA going.
Keep in mind, just because you put the money into an IRA account, does not mean it is automatically invested. You will need to take the next step, and choose which funds to allocate your money toward.
There are a few different types of IRAs, and we are going to cover the basics here: Traditional IRAs and Roth IRAs.
Note: you can contribute to just a Traditional account, or just a Roth account, or a combination of the two. The maximum annual contribution amount allowed ($6,000 up to age 49, or $7,000 if you are age 50 and older) refers to the total amount contributed to any type of IRA account.
Any contributions made to a Traditional IRA are reported on your tax return and receive a tax-deferral. You will pay taxes later (on both your contributions and your earnings/growth), when you withdraw the money. The advantage to a Traditional IRA lies here. It reduces your tax burden immediately.
This can be beneficial, especially if you are in a higher tax bracket now than you might be in retirement. Since your contribution isn’t included in your Adjusted Gross Income (AGI), this reduces the income amount taxed in the year you earned the income.
There are some income limitations here. If you are a high-earner, you can still contribute, but you may not be able to claim the tax deferral.
Roth IRAs are not tax-deferred immediately. Instead, you pay taxes on your regular income, which includes any amount that was contributed toward your Roth IRA. Once you’ve contributed to your Roth IRA, there the money stays to grow. The difference is, you do not pay taxes on the withdrawals (contributions nor growth) when you retire.
You can withdraw any amount you contributed to this account before 59 1/2 penalty-free (you cannot withdraw the growth without penalty).
Roth IRAs are particularly beneficial if you are in a lower tax bracket now, than you anticipate being in when retired.
Benefits of a Roth IRA are especially evident the further you are from retirement. This is largely due to the growth your account will see over time (through interest, price appreciation, and dividends) which are never taxed. While you do have to pay taxes immediately, you have the advantage of not paying taxes on alllll that beautiful growth afterward.
There are also income limitations with Roth accounts. If you are a high earner, you may not be able to contribute to a Roth account.
Rolling Over to an IRA
When you separate from employment, any money you have invested in employer sponsored retirement accounts, like a 401(k)/403(b), can be rolled over into your IRA. Advantages of rolling over your employer sponsored retirement plans into an IRA depend on the types of funds your former employer offered.
With your IRA, you may have access to more low-cost funds, compared to your employer sponsored plans (meaning less fees). You also have all your funds consolidated in one account making it easier to manage.
If you had funds in a Traditional 401(k)/403(b), they would be rolled over into a Traditional IRA. Likewise, if you had funds in a Roth 401(k)/403(b), they would be rolled over into a Roth IRA.
How is This Different From a 401(k)?
Essentially, an IRA is a retirement account that is held by you at a financial institution. An IRA account offers the same tax advantages as an employer offered retirement plan.
The maximum annual contribution for a 401(k)/403(b) as of 2019 is $19,000 (or $25,000 if you are age 50 or older).
The maximum annual contribution for an IRA is $6,000 (or $7,000 if you are age 50 or older).
Whether you have a 401(k), or an IRA, or both, the maximum annual contribution for each type of account refers to the total amount contributed, regardless of how it is divvied up between a Traditional or a Roth account.
You can, however, max out both your 401(k) and your IRA totaling $25,000 per year (or $32,000 if age 50 or older).
There are many advantages of having an IRA.
- I have mine because I want to have a place to rollover all funds from the various employers I’ve had over the years.
- Also, I enjoy having another retirement vehicle to put more money into, other than my 401(k).
- Lastly, I enjoy the autonomy of having an account that isn’t dependent upon any employer. This is especially crucial within the field of freelance work.
Ultimately, it is up to you if you open up an IRA, where you open up an IRA, and how you allocate your funds within an IRA. If you have access to an employer sponsored retirement account that has subpar fund options, or you want to have a separate retirement account to dump more money into, an IRA is a solid addition.
To learn more about other retirement options, check out these other posts I’ve written: