What Is an IRA?
IRA stands for “Individual Retirement Account.” There are several types of IRAs, but all of them offer some tax advantages to help you fund your retirement years. IRAs can be invested in a broad range of assets, including mutual funds, stocks, bonds, and ETFs (exchange-traded funds). Some—but not all—IRAs can even invest in commodities and real estate.
It’s fairly easy to grasp the overall concept of an IRA. A company creates an IRA that contains carefully chosen assets it believes will generate large returns for investors. At the same time, IRA managers can choose to include safer investments to offset risk. The amount of risk can vary tremendously between IRAs, so it’s always smart to do some research or talk to a professional before you decide which ones will likely meet your investment goals.
As mentioned above, there are several types of IRAs. The following list will familiarize you with the various advantages they offer.
Traditional IRA
A Traditional IRA gives you a tax break on the money you put into your account. For instance, if you put $5,000 into your traditional IRA this year, the government will not tax you for that money. It’s almost like the money got teleported into an alternate universe where it sits untouched and produces returns.
As long as you keep your money in the traditional IRA, you will not pay taxes on it. Once you withdraw money from your account though, you pay taxes on that amount. The tax rate will depend on how much income you generate that year and how rates change over time. Really, there’s no way to predict what taxes will look like a few decades from today.
The benefit here is pretty obvious. You don’t pay taxes on the money you contribute to your Traditional IRA. That could help you stay in a lower tax bracket, which means you keep more of your money. The downside, of course, is that you have to pay when you take money out of the account. Ideally, that will be a much larger amount than you invested, so you might end up paying higher taxes over your lifetime.
In 2022, you can contribute up to $6,000 per year to all (Traditional and/or Roth) IRAs. If you’re 50 or older, you can add an extra $1,000 in “catch-up” money.
Roth IRA
A Roth IRA takes the opposite approach. The money you put into your account gets taxed just like the rest of your income. You do not get any tax break during the years you invest.
In return, you don’t pay taxes on the money when you withdraw it from your account. Don’t get too excited, though! There are some rules for Roth IRAs. If you take the money out too early in life—before the typical age of retirement—you will pay a penalty.
As long as you leave the money alone until you reach the right age, you can withdraw funds without handing any of it to the government. Assuming that your Roth IRA performs well, you could avoid a considerable amount of taxes over your lifetime.
Roth IRAs have the same contribution limits as traditional IRAs. In 2022, that’s $6,000 for people under 50 and $7,000 for people 50 and older.
SEP IRA
A SEP IRA is a subset of Traditional IRAs that lets your employer contribute to your account. SEP stands for “Simplified Employee Pension.” Like a Traditional IRA, you don’t pay taxes on the money that gets invested. Instead, you pay taxes when you withdraw from the account.
SEP IRAs have one huge advantage over most traditional IRAs: your employer can contribute much more money! In 2022, employers could put up to 25% of your salary or $61,000 (whichever is lower) into your SEP IRA.
SIMPLE IRA
SIMPLE IRA (SIMPLE stands for “Savings Incentive Matching Plan for Employees”) has the same tax arrangement as a Traditional IRA. You avoid taxes on the money you invest, but you pay when you withdraw from your account.
SIMPLE IRAs have higher contribution limits than traditional IRAs. In 2022, you can put up to $14,000 in a SIMPLE IRA. Anyone 50 or older can add an extra $3,000.
There is a slight catch to the SIMPLE IRA. Small businesses often use it as an alternative to 401(k) plans. Because of this, employers need to match some of your contribution—usually up to 3%—or a percentage of your annual pay (usually 2%).
Recommended: Self-directed IRA
IRA case study
After graduating from college, Kevin gets his first job at 21 years old. He finally has some money that doesn’t go to buying necessities. Being the type of person who plans for the future, he decides to open a Roth IRA. He adds $5,000 the first year and makes $5,500 in contributions annually.
The Roth IRA that Kevin chose has an expected 7% rate of return. Not too ambitious, but still pretty good. It’s a safe option for long-term growth, and it meets his retirement goals precisely. When Kevin retires at 65, he will have over $1.6 million to fund his retirement. And he won’t have to pay a penny in taxes. All of that money belongs to him!
The bottom line
IRAs have tax incentives that motivate people to invest in retirement. There are several options though, so you will need to compare opportunities to decide which one fits your income and financial goals.
