Learning the IRA basics begins with understanding what an IRA is. According to the IRS, an IRA stands for an individual retirement arrangement. The IRA acronym also stands for an individual retirement account. It is a type of investment product that can help you to save money for your golden years. This is an IRA 101 overview, and you will learn that there are multiple types of IRAs from which you can choose.
The different types of IRA accounts may offer different benefits, have different contribution limits and different tax implications. It is important for you to understand the IRA basics so that you can choose the type of account that might help you to accomplish your retirement goals.
What does IRA mean?
If you are wondering what IRA means, it is a type of individual retirement account that you can open on your own. The meaning of IRA is common question – an IRA allows your money to grow in a tax-advantaged way, which can help you to enjoy a good income so that you can be more comfortable after you retire.
When you set up an IRA account, you open it at a financial institution. The money that you deposit can either grow on a tax-deferred basis or with tax-free growth, depending on the type of IRA account that you choose.
Statistics about IRAs
According to data published by ICI Research, one-third of the households in the U.S. owned IRAs in 2018. The most popular type of IRA that was owned by people was a traditional account. The second-most popular type was a Roth account. More than 50 percent of the people who reported having traditional accounts stated that they had rolled over employer-sponsored plans into their IRAs.
This makes sense because many people do not want to leave their accounts behind when they leave their former jobs. It can be difficult to keep track of multiple 401k accounts. By rolling employer-sponsored plans into an IRA, people can keep better track of their savings.
How do IRAs work?
The way your IRA might work and its IRA definition will depend on the type of IRA. If you have a traditional account, the IRA definition means the contributions that you make are made on a pre-tax basis. This allows your savings to grow tax-deferred until you retire. You will pay taxes on your distributions at the time that you begin taking them. You cannot make withdrawals before reaching age 59 1/2 without incurring stiff penalties.
If you have a Roth account, how your IRA is defined is that you make contributions on an after-tax basis. Your savings can then grow over time. When you make withdrawals after you retire, you will not have to pay taxes. Roth accounts also allow you to withdraw money from your principal balance without incurring penalties or paying taxes before age 59 1/2. We will delve into how the different IRAs work and what an IRA means in more detail below.
Types of IRAS
There are a few different IRA types that affect how an IRA is defined, including the following:
- Traditional IRAs
- Roth IRAs
- 401k plans
- SIMPLE IRAs
Each of these different types of IRAs offers its own benefits and disadvantages. Choosing the type of account that best meets your goals and needs might be easier when you understand how each of these different types of IRAs works.
A traditional IRA was first established under the Employee Retirement Income Security Act of 1974. Prior to the enactment of ERISA, regular IRAs also existed. IRA accounts are accounts that are held by a financial institution.
Anyone is able to contribute to an IRA if they have enough income to do so. There are restrictions on the ability to take a tax deduction based on your income, the other plans that you have, and filing status. A traditional IRA has an annual contribution limit of $6,000 if you are younger than age 50. If you are older than 50, you can make annual catch-up contributions of $1,000 for a total amount of $7,000.
Contributions are made on a pre-tax basis. They can grow tax-deferred until you begin making withdrawals. You will pay taxes on your withdrawals at the tax rate that you have at that time.
Established by the Taxpayer Relief Act of 1997, the Roth IRA was named after William Roth, the Senator from Delaware who sponsored the bill. Roth IRAs have several important differences from traditional IRAs. Like traditional accounts, you are limited to annual contributions of $6,000 if you are under age 50 and catch-up contributions of $1,000 per year if you are over age 50.
Unlike a traditional account, a Roth allows you to make contributions after tax. While you cannot take tax deductions, you also will not be taxed when you later withdraw the principal from your account. A Roth IRA is a good choice for people who believe that they will fall into a higher tax bracket when they retire.
There are income limits for contributing to a Roth IRA. If you are single, you can only contribute if your income is less than $137,000 per year. If you are married, you cannot make contributions if your joint income exceeds $204,000 per year. There are also phaseouts of the maximum contributions at specific income levels.
The history of the 401(k) account began in the early 1970s. A group of Kodak employees who were high-earners asked Congress to allow them to invest a percentage of their incomes in the stock market. Subsequently, section 401(k) was added to the Internal Revenue Code to allow this to occur.
A 401k plan is a plan that is sponsored by employers. Employees are able to make elective deferrals from their incomes on a pretax basis to their 401k accounts. The money is then invested by the fiduciary into a variety of different investment products.
The contribution limits on a 401k plan are higher. Employees are able to contribute up to $19,000 per year from their salaries. Employers may choose to make matching contributions or to not do so. The money is contributed on a pre-tax basis, meaning that your savings can grow tax-deferred. You will be taxed when you begin withdrawing the money after age 59 1/2 at your then-current income tax rate.
The SEP is a variation of the IRA that was established by the 1978 Revenue Act. The SEP IRA stands for the Simplified Employee Pension Individual Retirement Arrangement. It is a type of plan that employers can offer to their employees as a fringe benefit.
All of the contributions that are made to a SEP are made by the employer. Employers are able to contribute up to 25 percent of an employee’s salary. The maximum contribution of an employer is $56,000.
In 1996, the Small Business Job Protection Act allowed the creation of a SIMPLE IRA. SIMPLE stands for Savings Incentive Match Plan for Employees. Employers can choose to offer this type of plan instead of a 401k because of its ease of implementation and relative simplicity.
The elective deferral annual contribution limit of a SIMPLE IRA is $13,000. Individuals who are older than 50 can make an additional catch-up contribution of $3,000 per year. Contributions are made on a pre-tax basis so that your account can grow tax-deferred. When you retire, you will be taxed at your existing tax rate at that time.
There are different contribution limits and eligibility rules, depending on which type of IRA account that you choose. For traditional and Roth accounts, people who are younger than age 50 may contribute $6,000 per year. When they are ages 50 and older, they can contribute an additional $1,000 per year for a total of $7,000 per year.
SIMPLE accounts have higher contribution limits. If you are younger than 50, you can contribute $13,000 per year. If you are older than 50, you can contribute an additional $3,000 per year for a total of $16,000.
SEP-IRAs are different because the employers make the contributions instead of the employees. With these types of accounts, employers may contribute up to 25 percent of an employee’s annual salary up to a maximum of $56,000 per year. 401(k) accounts are employer-sponsored plans with higher contribution limits. You are allowed to contribute $19,000 per year to your 401(k) through elective deferrals from your salary.
The eligibility rules for each type of account are as follows:
- Traditional IRA account – Anyone can participate regardless of age or amount of income as long as they have enough income to contribute;
- Roth IRA account – People can contribute if they make less than the income limits, which are $137,000 Modified Adjusted Gross Income for single people and $204,000 MAGI for married couples;
- SEP-IRA – Must be at least 21, have worked for the employer for at least three out of the past five years, and have an earned income from the employer of at least $600;
- SIMPLE IRA – Must work for a sponsoring employer with fewer than 100 employees and have earned at least $5,000 in two recent years with an expected income of more than $5,000 in the upcoming year; and
- 401(k) – Is at least age 21 and has worked for the employer for a minimum of one year.
Deductions might be available to you, depending on the type of IRA account that you open. Contributions to traditional accounts may be deductible, depending on your income and tax filing status. Contributions to Roth accounts are not deductible, but you will not be taxed when you make withdrawals after you retire.
SIMPLE and SEP-IRAs provide tax deductions to the employers who make contributions to the plans. With 401k accounts, employees are not able to claim a tax deduction because the money was subtracted on a pre-tax basis and is not included in their modified adjusted gross incomes. However, making contributions to a 401(k) reduces your gross income so that you will pay less in taxes.
People sometimes choose to roll over their accounts into other types of IRA accounts. For example, people who quit jobs at which they participated in employer-sponsored plans might choose to roll over their savings to accounts at their new jobs or to traditional or Roth accounts.
It is important for you to know the rollover rules for your particular type of account. For example, a SIMPLE account cannot be rolled over into another type of IRA within the first two years, or it will be counted as a withdrawal and assessed a 25 percent penalty. Traditional accounts should be directly rolled over to the new account so that you can avoid incurring a 10 percent early withdrawal penalty if you are under the age of 59 1/2. The key thing is that you should make certain that you know the rollover rules so that you can avoid making costly mistakes.
The withdrawal and required minimum distribution rules are likewise important to know. If you have a 401(k), a traditional account, or a SIMPLE account, you cannot make withdrawals until you reach age 59 1/2. When you reach age 70 1/2, you will be required to begin taking minimum distributions beginning on April 1 following when you turn that age. You also cannot make any more contributions to these types of accounts after that time.
Roth accounts have different rules. You are allowed to withdraw some of your principal balance before you reach age 59 1/2 without incurring penalties or taxes. If you withdraw your earnings, however, you may be taxed on that portion. Roth accounts do not have a required minimum distribution, and you can continue contributing to your account as long as you want.
Retirement investment options
You might have more investment options with individual accounts than you might with employer-sponsored plans. Traditional and Roth accounts typically offer you a much broader choice in the investments that you can choose.
401(k) plans are generally limited to around 20 investment options that have been pre-selected by the plan’s fiduciary. SIMPLE plans may also be similarly limited, and there are certain types of investments that are disallowed such as collectibles. Having more options may allow you to create a customized portfolio that might help you to build more wealth.
There are different tax benefits with different IRAs. Contributions that you make to traditional accounts are deductible in the year in which they are made. Your savings can grow on a tax-deferred basis in a traditional account. However, you will be taxed on your distributions when you begin taking them.
Roth contributions are not deductible when you make them. Since they are made after you have paid taxes, you will not be taxed when you begin taking withdrawals after you retire. A Roth account might be beneficial to people who believe that they will enter a higher tax bracket in the future.
A beneficiary can be named to receive the proceeds of your IRA after you die. The way in which the inheritance will be treated will depend on the relationship the beneficiary has to you. A spouse can treat the IRA as his or her own or roll it into his or her own account.
Beneficiaries of traditional accounts who are not spouses cannot treat the IRAs as their own. The beneficiary will not be taxed until he or she begins taking distributions. A Roth account must be distributed in its entirety within five years unless an annuity has been established for the expected lifespan of the beneficiary.
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