Pensions

What is an IRA? Complete Guide to Individual Retirement Accounts

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Recent studies into the financial health of millennials, people aged between 21 and 37-years old, shows that they are in a shocking state of financial literacy. More than 23-percent of millennials spend everything they earn, and over 60-percent live paycheck to paycheck – with less than $3,000 in savings for use in times of emergency.

This sorry state of financial affairs means that most American millennials are woefully unprepared for a life-event that requires them to have savings. Can you imagine if you have to pay for a medical emergency and can’t afford the treatment?

Saving is an essential part of our financial health – without savings, you have an uncertain financial future. American millennials chose to place themselves in debt, rather than save.

With the average student loan balance being $37,000 after graduation, and the adoption of credit cards to pay off a lifestyle they cannot afford, the next generation of American adults are at risk of not being able to afford their retirement. As a result, we can expect these millennials to remain in the work-force until they are no longer physically capable of work.

How Do I Start Saving?

After reading the introduction to this article, you should understand that savings are a critical component of your fiscal health. Not everyone gets the opportunity to start a business and become a millionaire overnight – the majority of the population will have to enter the workforce and spend the next 40-years of their life working for someone else.

While we all imagine that we can grab the American dream of building a business and amassing wealth, the truth is that most of us will have to work for it. This fact doesn’t mean that you can’t earn a good living or start to amass wealth through working for someone else. All it means is that you need to look at alternative means of growing your money.

Any savvy investor will tell you that the hallmark of investing is putting your money to work for you, rather than working for your money. While most of us aren’t in the position to qualify as an accredited investor, we still have the opportunity to leverage the time and skills of experts to help us grow our money for retirement.

A savings account is a useless financial vehicle. If you’re stuffing all your earnings into a savings account, then you’re missing out on potential returns. Most banks don’t offer interest on deposits, meaning that your money slowly loses its value through the deduction of bank fees from your balance, as well as the erosive effect of inflation on your capital.

So, how do you start saving for retirement? One of the best financial vehicles available to mom and pop investors – is the IRA.

Individual Retirement Accounts Explained

Financial firms offer IRA products to investors that want to contribute toward their retirement. Therefore, an IRA has a fixed investment term that starts at the date of your first contribution, and continues to your retirement date, usually at age 60 or 65.

There are currently numerous IRS products available, including; traditional, Roth, SIMPLE, and SEP IRA’s. Each has its unique set of terms and conditions relating to contributions, early withdrawals, and most importantly – tax.

Traditional and Roth IRAs are financial vehicles geared toward employees, while SIMPLE and SEP IRAs are for self-employed persons and business owners. When choosing an IRS product, the consumer must do business with a select group of financial companies, brokers, and banks, savings and loan associations and federally insured credit unions – typically, individual taxpayers open their IRA with a broker.

The IRA works by providing purchasing power to consumers engaging in investing. Should the investor try to allocate their funds to an investment vehicle, without the support of additional investors and advisors, then they place a cap on their returns due to the amount they can invest, as well as their expertise in investing.

By contributing to an IRA fund, you are one of hundreds or thousands of investors pooling your money into the investment account of a prominent financial investment firm. As a result, you benefit from the pooled funds allowing for higher rates or return – as well as managing your risk. An investment manager controls the allocation of funds to investments, and they may choose to invest in stocks, bonds, mutual funds, tax liens, and private funds.

By using an IRA, you benefit from the expertise of the account manager, without knowing anything about the market or how to invest your money. By using an IRA, you rely on professional advice and action, while taking a hands-off approach to your investment strategy.

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The Types of IRA’s and Tax Deductions

The type of IRA you chose depends on whether or not your employer currently runs a plan, as well as the tax commitments to the investment. Age also plays a role in selecting the right type of IRA, as does your income.

Here are the types of IRA’s explained in further detail, along with the tax-deductible benefits they offer the investor.

Traditional IRAs

Traditional IRA’s suit GenXers, as they are closer to retirement than millennials. While GenXers are typically in a higher tax bracket, they benefit from the tax-deductible contribution. If you contribute $6,000 to your IRA over the course of the year, you can claim this amount as a deduction when it’s time to submit your income-tax return, and the IRS does not apply income tax to those earnings.

With a traditional IRA, the government taxes you on withdrawals from your account during retirement – at the ordinary income tax rate. The government limits the amount you can contribute to the IRA over the course of the year, as of 2019, it’s a $6,000 limit. Individuals over the age of 50-years may contribute $7,000 per annum in catch-up contributions.

Should you be the head of a household or single person with an IRA through your employer, and a modified adjusted gross income of $64,000 or less, then the IRS states that your contributions to your account are entirely deductible. For married partners, the limit is $103,000 or less.

The tax deduction on contributions may also depend on the type of IRA your employer offers. Some companies have tailored plans for employees in all tax brackets, with common incentives across the board. Before signing up with your employer’s IRA, ask them if they make any contributions to match your own. Top companies will match the same amount you put into the account, making it worthwhile to consider going with the company plan.

However, if your employer offers a traditional plan, and you’re under the age of 35, then you might want to consider looking into another private option from an accredited financial institution.

Another critical point to note is that holders of IRAs must begin taking their required minimum distributions by age 70.5-years. The plan allocates the RMD based on life expectancy and amount of funds available. Failure to withdraw these minimum amounts will end up resulting in the IRS applying a tax penalty equating to 50-percent of the value of the RMD.

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Roth IRAs

In 2001, Senator William Roth launched a bill that led to the creation of the “Roth IRA.” Roth had a vision where Americans would turn around their current consumerist behavior and focus more on savings.

The Roth IRA focuses on millennials, aged 21 to 37. We’ve already outlined the dismal savings rate in this generational bracket, and the Roth IRA provides a solution that allows millennials to save towards their retirement.

The Roth IRA is not tax deductible. The individual pays tax towards the contributions they make to the account based on their tax bracket. However, qualified distributions are entirely tax-free. This structure allows millennials to benefit from the fact that they are in a lower tax bracket during the start of their career.

The Roth IRA allows millennials to make contributions while they are in a lower tax bracket, and receive a tax-free payout when they are in a higher tax bracket at the end of their career when a person with a traditional IRA would have to pay tax on their withdrawal.

Essentially, this means that the individual uses after-tax dollars to contribute to the Roth IRA. However, as the IRA grows, you don’t have to pay any taxes on capital gains. Roth IRA’s also have no RMD, with no penalties for late withdrawals.

The cap on contributions to Roth IRAs in 2019, is the same as a traditional IRA. The individual has a maximum threshold of $6,000, and $7,000 for those over the age of 50-years old. There are also limitations on cumulative household incomes applying for a Roth IRA. Married couples must have a combined MAGI of under $193,000 – while a single person or the head of a household has a limit of $122,000.

It’s critical to note that for both traditional and Roth IRA’s, should your tax status with the IRS be, “married filing separately,” and you do not live with your spouse, or have not lived with your spouse for the entire tax year, then you qualify for the income limits and deductions of a single person.

Simplified Employee Pension (SEP) IRAs

Small business owners, contractors, freelancers, and self-employed individuals can benefit from setting up a SEP IRA. This type of IRA has the same rules as a traditional IRA for taxation on any withdrawals, but it limits contributions to 25-percent of income or $56,000 for the year – whichever amount is less.

Those business owners that decide to set up a SEP IRA for their employees may deduct the contributions to the IRA from their reported business income, potentially setting them up a lower tax rate on their income.

It’s important to note that company employees are not allowed to contribute to this type of IRA, and the Internal Revenue Service’s count any withdrawals as income, and tax it at the relevant bracket. Employees can also open an IRA with another financial services institution and start contributions.

Savings Incentive Match Plan for Employees (SIMPLE) IRAs

Small business owners and self-employed individuals can benefit from setting up a SIMPLE IRA (Savings Incentive Match Plan for Employees). This type of IRA follows the same rules and regulations as all the other IRA products regarding withdrawals.

However, where the SIMPLE plan differs from the SEP plan, is in the fact that the employees can make contributions to the IRA as well. Many top companies offer this type of IRA, and all contributions are tax-deductible, which provides the benefit of potentially edging the employee or business into a lower income-tax bracket, which reduces the tax bill.

Limits for employee contributions to the SIMPLE IRA for 2019 is $13,000, with the government making provision for a $3,000 catch-up contribution, for those employees over the game of 50-years old.

Tips for Selecting a Private IRA

If your employer does not offer an IRA plan, then you have the right to go out and source one from the market. When selecting your IRA, it’s vital that you understand risk exposure. Many IRA’s will offer you, the client, with the option in investing in tiered-risk IRA products.

When you sign-up for the IRA, the consultant asks you if you would like to invest your contributions in a low, medium, or high-risk portfolio of assets controlled by the investment firm. The high-risk option will offer the best percentage returns, but you may run the risk of losing a significant portion of your savings should the economy experience another financial crisis.

Choose your risk profile based on the length of time you have left in your IRA. IF you’re a few years away from retirement and need to catch up on your savings, a high-risk portfolio may provide you with the returns to enjoy your senior years.

However, if you’re starting your career and have your best years in front of you, then try a low-risk approach to safeguard your investment from any market-related pitfalls in the future.

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Conclusion

Private persons, employees, business owners, and contractors can all benefit from the use of Individual Retirement Accounts as an investing tool to earmark their savings for retirement.

Different IRAs offer different benefits for employers and employees, as well as various tax liabilities.

Your income, occupation, age, and investment goals are top factors that determine which IRA is right for you.

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Oliver Dale is Editor-in-Chief of MoneyCheck and founder of Kooc Media Ltd, A UK-Based Online Publishing company. A Technology Entrepreneur with over 15 years of professional experience in Investing and UK Business.His writing has been quoted by Nasdaq, Dow Jones, Investopedia, The New Yorker, Forbes, Techcrunch & More.He built Money Check to bring the highest level of education about personal finance to the general public with clear and unbiased reporting.oliver@moneycheck.com

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