There are numerous options when it comes to options to set up retirement savings in the US. Individual retirement accounts or IRAs are a popular choice for people seeking to invest as they offer a lot of flexibility. They can be a bit tough to figure out though, so we’re going to give a straightforward explanation of all the options and their upsides.
What is an individual retirement account (IRA)
An IRA (individual retirement account) is a private, tax-deferred account that the IRS established to provide investors with a simple method of organizing retirement savings. With this account type, your retirement funds can grow quicker than they would in a taxable account. An IRA is mainly for independent contractors who lack access to a 401(k) which is typically offered through permanent employment at a company.
There are a lot of options when it comes to opening an IRA on your own and you can do it in practically any insurance company, brokerage firm, bank, or investment firm. With an IRA you have a vast array of investment options to start saving for your retirement.
What advantages do these retirement options offer:
Depending on the kind of IRA you pick, you can avoid your taxes on deposits with a deduction or reduce them later when tax-free distribution starts.
Grow your account with annual interest accrued, dividends, and capital gains profits that won't get whittled away by taxes.
Choose from a selection of investments than what is typically available in 401(k)s or other employee retirement plans.
Create an IRA to begin saving for retirement or to top off and diversify any existing retirement funds you may have.
What are the different IRA types you can choose
Depending on which of these you get, your benefits and obligations towards the account can vary drastically.
Traditional IRAs are defined as individual retirement accounts which enable you to deposit pre-tax funds and have tax-deferred growth on your investments. The owner of a traditional IRA must cover income taxes on withdrawals made during retirement.
Individual contributions to traditional IRAs cannot go over $6,000 yearly in 2021 and 2022. If you are 50 years or older, you can make annual contributions of up to $7,000.
A Roth IRA on the other hand allows after-tax contributions. Your contributions and earnings can grow tax-free, and you can withdraw them tax-free and penalty-free upon reaching the age of 59½ and once the account is five years old or older.
One downside is that Roth IRA contributions are subject to income limitations so they might not work for everyone. The contribution caps for traditional and Roth IRAs for the tax years 2021 and 2022 remain the same.
A SEP (Simplified Employee Pension) IRA is a type of account that an employer or self-employed person can set up. Employers may deduct their contributions to SEP IRAs and make discretionary contributions to the plans of their eligible employees. Compared to traditional IRAs, SEP IRAs frequently have higher annual contribution caps.
SEP IRA contributions for 2022 remain capped at $61,000 or 25% of compensation, whichever is less.
With SIMPLE IRAs (Savings Incentive Match Plans for Employees), the employer and the employee contribute to the accounts. Since every contribution is tax deductible, it may help the company or employee fall into a lower tax bracket.
The employee contribution cap for the SIMPLE IRA is $14,000 in 2022 from $13,500 in 2021. The catch-up limit (for employees over 50) will remain at $3,000 in 2022.
Where should I open an IRA
Most major financial institutions, including banks, brokerage firms, and mutual fund companies, will help you open an IRA. It’s an important step to select a service provider who meets your preferences and this will take some research and comparisons.
For investors who stress over making choices, robo-advisors are excellent. Choose one with services that suit your needs and a low management fee, ideally around 0.40% or less.
For new investors, consider a broker with no account fees and low commissions. They must offer a broad selection of commission-free mutual funds and exchange-traded funds without transaction fees.
How to open a Traditional IRA or Roth IRA
Do you prefer to be a hands-on or hands-off investor? This decision will help you choose between opening an IRA with a robo-advisor or an online broker.
To choose and manage your assets, you must work with an online broker.
Consider using a robo-advisor if you want to use the automated method to manage your investments.
Opening an IRA is simple; the precise steps will vary slightly depending on the provider. In general, you visit the provider website, select the kind of IRA you want to start (traditional or Roth) and provide personal information like your Social Security number, birth date, contact information, and place of employment.
Funding the account
Once you decide on the provider, you can transfer funds from a bank account.
In 2022, the annual contribution cap for IRAs is $6,000 and $7,000 if you are 50 or older. Income restrictions apply to traditional and Roth IRAs alike. Traditional IRAs only have income limits if you or your spouse also have a workplace retirement account.
Rolling over a 401(k)
A 401(k) rollover allows you to transfer money from the 401(k) plan of an old job into the retirement plan of your new company or an IRA.
You'll get assistance with this from the IRA provider. But first, contact your former employer's plan administrator and fill up a few forms, after which they will deliver your account balance to your new provider.
The Bottom Line
Retirement savings is the fundamental goal of an IRA. Early withdrawals will undermine that goal by reducing your retirement assets. Therefore, money saved in an IRA is usually not withdrawable before the age of 59½ without paying a significant tax penalty of 10%. Otherwise, retirement savings accounts like IRAs have a tax advantage that you should definitely consider.