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IRAs exist for one reason: to shield you from taxes while you invest for retirement.
There are four types of IRAs, which stands for Individual Retirement Arrangement, though most people know them as individual retirement accounts. Two of them, a Roth IRA and a traditional IRA, are the ones you’re most likely to use. IRAs can be opened by nearly anyone, and you can use them to put your money into a wide range of investments.
The earlier you get started, the more money you’ll have.
Don’t get bogged down in the details. Learn how to open an IRA and be on track to retirement.
“Getting started early is crucial, because compound interest is so important. It’s earning money on your money,” says Dominique Broadway, personal finance expert and CEO of Finances Demystified. “IRAs are great because they make your money work for you. The earlier you start saving, the less you have to save.”
Don’t let the nuances of each account stop you from getting started. Investing early and frequently is the secret to a wealthy retirement. Read on to learn about the different types of IRAs that are best suited for you and how to get started with investing for your future.
What Is an IRA?
An IRA is a tax-advantaged retirement account that lets you save for retirement. To put it plainly, you put money in, invest it, and you take the money out when you’re ready to retire. Each account offers you a different type of tax exemption or tax benefit. In some cases, there are penalties if you withdraw your money before age 59 ½.
Depending on your retirement goal and journey, one might be better for you than the other.
These are the four main types of IRAs:
Many financial experts swear by a Roth IRA, and for good reason. A Roth IRA works almost like a glorified savings account. Whatever you put in, you can take out without penalty. But experts agree you don’t want to take out money unless you really have to, so that compound interest can work in your favor.
Each year, you are allowed to invest $6,000 into your Roth IRA if you’re under 50 and $7,000 if you’re over 50. There are income limits the government sets, too. If you are single and make over $140,000 (adjusted gross income) for the 2021 tax year, you are not allowed to invest in a Roth. If you are married, income must be under $208,000 for tax year 2021.
“It’s important to make sure you contribute as much as you can to your Roth IRA before you start making the big bucks,” says Broadway.
Here’s the best part about a Roth IRA. That money sits in there for many years and compounds on itself. When you’re 59 ½, you can take all that money out, even the growth, and not have to pay a single dollar of taxes. This is why we love Roth IRAs.
“If I could tell my 25-year-old self one thing, it would be to maximize your Roth IRA and be aggressive. You definitely want time on your side,” says Jennifer Lee, a financial advisor and the founder of Modern-Wealth. “It’s the greatest thing since sliced bread.”
Money you contribute to a Roth IRA can be taken out at any time without penalty. However, you’ll pay a penalty if you withdraw your money’s growth—as in, the investing profits your contributions have earned—if you withdraw those before age 59 ½. There are certain exceptions to this rule. The government lets you avoid paying taxes on earnings if you’re using the money on a first-time home purchase, education expenses, paying for a birth or an adoption, if you become disabled or pass away, or if you need to pay for a medical expense or health insurance if you’re unemployed.
A traditional IRA works differently from a Roth. You put in pre-tax dollars, meaning you get a tax deduction today when you deposit. But in the future, you have to pay taxes when you withdraw the money. That amount will depend on your tax rate at the time.
Unlike a Roth IRA, there are no income limits for a traditional IRA, but if you have access to a retirement plan at work, you may not be able to deduct all your IRA contributions on your taxes. There is a limit as to how much you can deposit into your traditional IRA each year. It’s the same as a Roth IRA, which is $6,000 in 2021 if you’re under 50 or $7,000 if you’re older than 50.
Same as a Roth, you can pull money out of a traditional IRA when you’re 59 ½. If you take it out sooner than that, you can expect a 10% tax penalty. The government does have exceptions in place (like a Roth) if you really need to take out the money before you hit your retirement age. Those exceptions are disability, terminal illness, medical expenses, some tax payments to the IRS, higher education payments, first-time home buyer purchase, and using the money for health insurance when you are unemployed.
A Rollover IRA is an account that lets you move funds from a previous account (like an employee-sponsored 401(k)), to preserve the investment account and not pay taxes or early withdrawal penalties. You fund this account with money “rolled over” from your other retirement accounts. You can roll over these accounts into either a traditional IRA or a Roth IRA. A rollover IRA doesn’t have yearly limits; you can roll over as much money into an IRA as you can.
A SEP IRA stands for Simplified Employee Pension. It’s a retirement account that is great for self-employed or small-business owners. Just like a traditional, contributions are tax-deductible now but are taxed at withdrawal. A SEP IRA is great because the contributions are 10x that of a traditional or a Roth. You can contribute up to $58,000 in 2021.
Why Have Both an IRA and a 401(k)?
Should you open up an IRA if you already have a 401(k)? The short answer: yes. It’s very common to have both types of accounts.
If you have access to an employee-sponsored retirement account like a 401(k), look to see if your employer matches your contributions and make sure you deposit enough to get that match—it’s free money. Afterwards, experts agree it makes sense to move the rest of your contributions to your IRA and max that out. Then you can go back to your 401(k) and max that beyond the match. You are allowed to contribute $19,500 a year to your 401(k) if you’re under 50, and $26,000 a year if you’re over 40.
Experts say that there is more flexibility with an IRA, when compared to an employee-sponsored retirement account like a 401(k). “If your employer-sponsored 401(k) only has ten funds to pick from, you have to choose one of those. If those funds are actively managed, you will pay more in fees over the lifetime of the account than you would in a passively managed index fund that’s held in your IRA,” says Alex Klingelhoeffer, a fiduciary financial adviser with Exencial Wealth Advisors.
IRAs have more flexibility with the ability to invest in index funds, stocks, mutual funds, ETFs and bonds.
How to Open an IRA
You can open up an IRA in ten minutes using your name, address, Social Security number, and date of birth. Find a discount brokerage account you like (like Fidelity, Schwab) and open one up there.
Choose which IRA is best for you. Compare the differences between a Roth and a traditional. If you’re self-employed, a SEP IRA might be for you.
Whichever you choose, the most important thing is just to choose one. “Here’s the truth: Whichever account you choose will help you set up a path for retirement, and that’s one of the most important money decisions you can make in your life,” “Broke Millennial” author Erin Lowry told NextAdvisor.
Most brokerage accounts require little to no minimum to get started.
After you open the account, you will need to fund it and choose your investments. You can choose between index funds, ETFs, stocks or bonds. The most commonly recommended investments are index funds, which helps spread out your investments in the entire stock market.
Make sure your money is being invested. Once you contribute to an IRA, it’s easy to think your money is working, but most often, it’s just sitting in the account. Make sure to call your brokerage account and make sure your money is being invested. When you don’t invest your money it’s like “putting money on a gift card, but you’re not spending the money,” personal finance expert Tori Dunlap told NextAdvisor.
If you’re rolling over money from another account, like a 401(k), you’ll need to call up that company, let them know where the new account is, and request a paper check. They’ll typically mail you a check that is made out to the other brokerage for your benefit. Once you deposit that, your IRA will be funded.
What is the difference between a Traditional and Roth IRA?
It comes down to taxes. When you use traditional IRAs, you are taxed at withdrawal. With a Roth IRA, you contribute money you’ve already been taxed on, and it grows tax-free until 59 ½. You can take out the money you put in from your Roth without penalties, but you don’t want to. The interest you make can’t be taken out before 59 ½ without penalties, unless you are using it for one of the exemptions the IRS gives (see above).
Which is better, a traditional or Roth IRA?
Well, it depends. With a Roth IRA, you get a tax break in the future. With a traditional IRA, you get a tax break today. Generally, if you expect to be in a higher tax bracket in the future, a Roth IRA makes sense, while a traditional IRA makes more sense if you plan to be in a lower tax bracket in the future. But whichever you choose, you’ll get a tax-advantaged path to retirement.
How long does it take to roll over an IRA?
That also depends. If you’re rolling a 401(k) account into an IRA at the same brokerage it could be a few days. If you’re moving from one brokerage to another and a check is being mailed, it might take about two weeks. Call your brokerage for more information.
With reporting by Lindsey Danis.