What does an IRA mean in plain English? What is a Roth IRA?
You likely have heard of an IRA, but you might not be certain about what it is. Many people ask, “What is an IRA in English?”. It is an individual retirement account. An easy to understand IRA definition is that it is an account in which the income taxes on your deposits and your gains are deferred until you begin taking withdrawals after you retire. On the other hand, a Roth IRA in English is termed as a tax-advantaged retirement account.
To put it more simply, an IRA is an individual account for retirement that you can set up on your own. It is not an account that is sponsored by your employer. You make contributions to your IRA before taxes are taken out. If you meet certain income requirements, you may also be able to deduct your contributions when you make them on your tax return. Your savings are able to grow in your account tax-free until you reach retirement and begin taking money out. At that time, you will be taxed on your withdrawals at your then-current ordinary income tax rate.
A Roth IRA is an retirement account where your contributions are taxed, so that the distributions in retirement are tax-free. This is another type of IRA account that is set up on your own and is not sponsored by your employer.
Statistics about IRAs and Roth IRAs
According to research from the Investment Company Institute, 43.9 million U.S. households own at least one type of IRA. Traditional IRAs are the most popular and are owned by 27 percent of all U.S. households. Roth IRAs are the second-most popular and are owned by 19 percent of all U.S. households. Altogether, 42.4 million U.S. households own traditional or Roth IRAs. The remaining households that own a type of IRA own SEP IRAs, SIMPLE IRAs, or SAR-SEP IRAs.
These statistics do not include ownership of 401(k) accounts, which are employer-sponsored plans that are offered by some employers. These statistics demonstrate that millions of people are taking steps to plan for their retirements by saving money in individual accounts whether or not they also participate in employer-sponsored plans at their jobs.
How do you set up an IRA and a Roth IRA?
To understand the IRA basics, you need to learn how to set up an IRA or a Roth IRA. Setting up either account is simple. You can set up an IRA or Roth IRA by following these steps:
- Choose the firm or financial institution that will hold your account
- Determine which type of IRA you want to open
- Complete the application documents
- Determine your risk tolerance
- Choose your investments or pick a portfolio that has been created for your risk level and time horizon
- Fund your account
Some firms and financial institutions also allow you to set up automatic transfers from your bank account so that you can continue contributing to your account without thinking about it.
Simple explanation of a traditional IRA
The IRA basics also include understanding the facets of a traditional IRA. For this type of account, the contributors are individuals. There are annual contribution limits for this type of IRA. If you are younger than age 50, you are allowed to contribute a maximum of $6,000 per year. People who are 50 or older are able to make catch-up contributions of an additional $1,000 per year, bringing their total maximum contribution to $7,000 per year.
When you make contributions to a traditional IRA, your money goes into your account pre-tax. This means that your money is allowed to grow on a tax-deferred basis until you begin taking disbursements. How are IRA distributions taxed? IRA distributions are taxed at your ordinary income tax rate at the time when you take them.
Under the IRA withdrawal rules, if you take out money before you reach the IRA withdrawal age of 59 ½, you will be assessed 10 percent. The only way to avoid this withdrawal penalty on your early IRA distribution is when an exception applies. When you reach age 70 ½, you will have to begin taking required minimum IRA distributions of 4 percent of your account balance.
A traditional IRA offers the following advantages:
- May be able to deduct contributions on your taxes
- Savings grow tax-deferred
- Anyone can open an IRA regardless of income
- Broad selection of investment choices
If you believe that you will be at a higher tax rate when you retire, it may make more sense to open a Roth IRA because traditional IRA distributions are taxed at your income tax rate at the time that you take them. The contribution limits for traditional IRAs are also relatively low. Finally, the IRA required minimum distributions that begin when you reach age 70 ½ mean that you will have to take withdrawals whether you need them or not.
Straightforward explanation of a Roth IRA
While a traditional IRA is a pre-tax retirement account, a Roth IRA is an after-tax account because of how the contributions are made. Like a traditional IRA, the contributors to a Roth IRA are individuals. The same contribution limits of $6,000 for people under age 50 and $7,000 for people ages 50 and older apply. However, not everyone is eligible to contribute to a Roth IRA.
Roth IRAs have maximum income limits to make contributions. If you are single, your ability to make maximum contributions begins to phase out if you make $122,000 per year. If you make $137,000 per year, you will not be able to contribute to a Roth IRA. For married people, the phaseout begins when they make a combined income of $193,000, and they will not be able to contribute to a Roth IRA if they make a combined income of $203,000 or more.
While Roth IRA contributions are made on an after-tax basis, your disbursements are not taxed. This makes a Roth IRA a good choice for people who believe that they will be in a higher income tax bracket after they retire than they are currently in. The Roth IRA withdrawal rules have some differences from the traditional IRA withdrawal rules.
The minimum IRA withdrawal age for IRAs is 59 ½ for avoiding the early withdrawal penalties. For a Roth IRA, you can withdraw only your contributions without penalty as long as you wait five years from opening the account.
Under the Roth IRA withdrawal rules, you will face an early withdrawal penalty of 10 percent if you withdraw your earnings before you reach age 59 ½. However, some withdrawals are exempt from this, including the following:
- Up to $10,000 for a first-time home purchase
- Withdrawals taken because of disability
- Payment for medical insurance premiums if you have been unemployed for more than 12 consecutive weeks
- Payment for your own qualified higher education expenses or those of your children
- Distributions to your beneficiaries if you die
There are several advantages of a Roth IRA:
- No required minimum distributions
- Tax-free withdrawals
- Can contribute as long as you want
- Can leave your Roth IRA as a legacy if you do not need it
Some of the disadvantages of Roth IRAs include the following:
- Maximum income limits mean that not everyone can contribute to a Roth IRA
- Contributions are not deductible
Simple comparison of a traditional vs. Roth IRA
This table offers a simple comparison of a traditional vs. Roth IRA:
|Roth IRA||Traditional IRA|
|After-tax contributions||Pre-tax contributions|
|Pay taxes when money contributed||Pay taxes when money withdrawn|
|For individuals that meet the income requirements||For any individual|
|Contribution limit of $6,000 if younger than 50||Contribution limit of $6,000 if younger than 50|
|Catch-up contributions of $1,000||Catch-up contributions of $1,000|
|Penalties on withdrawals of earnings before 59 ½||Penalties on withdrawals before 59 ½|
|No required minimum distributions||RMDs beginning at age 70 ½|
Rollovers, conversions and backdoor Roth IRA explained
Rollovers occur when you roll funds over from one type of retirement account into another. These can include a rollover IRA, a 401(k) roll over to an IRA, and a rollover 401(k) to Roth IRA. As long as you follow the IRA rollover rules, you can roll money from one type of account into another without paying penalties.
Under the IRA rollover rules, you can initiate a direct transfer of your money from your old account to your new one by contacting the old plan administrator and asking him or her to send your funds directly to the holder of your new account.
You can also take the funds yourself and deposit them into your new account. However, if you do this, you must deposit the money within 60 days to avoid a penalty. A rollover IRA can be set up, and you can then roll funds over to the account from your old 401(k) or from another IRA without paying taxes or penalties.
Another concept that you should be aware of is an IRA to Roth conversion. A Roth IRA conversion is a way for you to open a Roth IRA even if your income exceeds the maximum income limits. You can complete a backdoor IRA conversion by completing the following steps:
- Open a traditional individual retirement account
- Fund the traditional account
- Ask the plan administrator for paperwork to convert the traditional account to a Roth IRA
- Complete the paperwork
- Be prepared to pay taxes on the amount that is converted from your traditional account to your new Roth IRA
This can allow you to benefit from a Roth IRA even if your income is too high.
Importance of IRAs and Roth IRAs in financial planning
Both regular IRAs and Roth IRAs are important to consider when you are engaging in financial planning. These accounts can help you to reach your savings goals so that you can retire comfortably. You are allowed to contribute to an IRA or a Roth IRA in addition to your 401(k) contributions through your job.
If you can, you should try to contribute the maximum amounts that you are allowed to each year. If you cannot contribute the maximums, aim to contribute at least 10 to 15 percent of your income each month. Making a habit of saving and investing can help you to reach your financial goals so that you can live comfortably during your retirement years.
How investing with M1 Finance works
The free investment platform that is offered by M1 Finance has several unique features that help to make IRA investing accessible to investors at all levels. The site allows you to choose the account that will meet your needs and goals. You can then pick your own investments or choose a portfolio that has been designed by experts for your risk tolerance level. You can also roll over old accounts from other institutions with ease.
M1 Finance provides you with a visualization so that you can see how your individual investments are performing over time. Investments that are performing well will grow while those that are underperforming will shrink. M1 Finance performs automatic rebalancing so that your account stays optimized, allowing your money to work harder for you.
Benefits and coverage of M1 Finance
M1 Finance does not charge any management fees or commissions. This means that you are able to invest for free and that you could potentially earn thousands more over time. The site offers you the ability to create your own custom portfolio or to choose from more than 100 portfolios that have been created by experts.
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