We all know……
It’s important to save for retirement. Everyone and their uncle preach that we start out with the same thing, our 401K’s or 403B’s, depending on where you work.
But how do you know that it’s enough to make your financial dreams a reality? Did you know there are other options you can invest in that gives you more choices, more control over your money, can enhance your 401K, AND can potentially provide tax breaks?
Today, we are going to discuss one of those options, IRA’s.
In today’s article, we will discuss what is an IRA, how it works, how different than 401K’s, benefits/ drawbacks, and so much more.
What Is An IRA And How Does It Work?
Individual retirement accounts (IRA’s) are an investment account with potentially large tax advantages and tax breaks. The IRA itself is not an investment but merely the holding account where your stocks, bonds, ETFs, and private investments are held.
IRAs were first made available to individuals in 1975 by the Internal Revenue Service to provide individual investors a tax-advantaged way to save and invest for retirement.
Many investors find these tax-advantaged investment accounts attractive because it can help meet retirement goals more quickly than investing in a 401K only. Plus, IRA’s can allow for more investment options than an employee-sponsored plan.
The money invested in an IRA can grow either tax-deferred or tax-free depending on which type of IRA is opened. By growing your money away from the clutches of Uncle Sam, your money can grow and compound each year without taxes eating away at it.
Because of these benefits, an IRA can be a great tool for saving towards retirement. Many people use an IRA to augment their other retirement accounts and to leverage the many tax benefits an IRA enables.
How Are 401K’s And IRA’s Different
You may be seeing some similarities between a 401K and an IRA so what makes each unique?
401K’s are employer – sponsored and usually offer matching contributions (aka company match). Matching contributions are a key reason why a person should invest in their company’s 401K. It’s basically free money being offered to them so why should you turn it down?
On the other hand, IRA’s are started and owned exclusively by the individual. However, there is no matching contribution.
Another reason to invest in 401K’s is the yearly allowable contribution limit. For 401K’s, the yearly contribution limit is about $20,500. For IRA’s, the maximum yearly contribution is $6,000 if under 50 years of age and $7,000 if over 50 years of age.
On the downside, 401K’s also tend to be more restrictive. You can only choose from the investment options offered by your company’s plan. IRA’s on the other hand provide you more options and more control over what you want to invest in.
IRA Drawbacks
As we talked about previously, IRA’s offer many tax benefits, investment options, and there are several types of IRAs to choose from that can meet your needs.
While these choices are great, there are some drawbacks to IRA’s.
First off, even though these are such great investment accounts, you can only contribute $6,000 / $7,000 annually depending on your age. Also, if you decide on opening multiple types of IRA’s, the combined amount invested in all IRAs cannot be more than the $6,000 / $7,000 contribution limit.
IRA’s also require you to be 59 ½ before you start withdrawing funds without penalty. Even though you could technically withdraw before 59 ½, you will incur a 10% penalty on the amount withdrawn (can you say ouch! ☹)
Plus, some type of IRA’s (i.e., Roth IRA), have income limits assigned to them. If your adjusted gross income (AGI) exceeds a certain level, you cannot invest in that type of IRA.
However, there are loopholes that we will touch on later.
Lastly, you also have an age limit where you must start withdrawing fund or else face penalties. This is to prevent a person from building up a sizeable account that remains untouched until gifted to an heir.
Because of this, IRA’s have a required minimum distribution age of 72. Starting at age 72, you must start withdrawing funds from your IRA.
However, there are loopholes to work around this. While the law says you MUST withdraw funds from your IRA, it does not say HOW you must use these funds once withdrawn.
There are several choices you could use this money for from traveling to family gifting to re-investing the money either in a brokerage account or a whole life insurance policy.
While the government is good at providing restrictions, a good accountant or tax attorney can help you plan how to make this money continue to work for you.
But what type of IRA may be right for you? We’ll cover that next.
Different Types of IRA’s
There are several types of IRA’s that may be right for you depending on your needs and overall financial strategy.
Traditional IRA
With a traditional IRA, you contribute money on a pre-tax basis and your money grows tax-deferred until you start withdrawing funds.
Once you start withdrawing funds, the government then treats the withdrawal as income and taxes you at the appropriate tax rate.
Put simply, with a traditional IRA, you pay taxes on the income and gains at withdrawal. Remember, Uncle Sam always want their cut and they receive it upon withdrawal with a traditional IRA.
Traditional IRA’s work best if you think your tax bracket will be lower in retirement.
You can open a traditional IRA account through a bank, brokerage, or an IRA provider. Note that some firms require a minimum investment amount to open an account, so you’ll want to do a little research beforehand to compare your options.
Roth IRA’s
This type of IRA was named after Delaware Senator William V. Roth Jr.
A Roth IRA allows you to use money that has already been taxed, invest it in a Roth IRA, grow tax-free, and then be withdrawn at a future date tax-free provided you meet certain requirements.
In other words, you pay taxes on the seed and not the harvest.
A traditional IRA is the opposite. You pay taxes on the harvest, not the seed.
Roth IRA’s also have income limits where if your income exceeds a certain limit, you cannot invest in a Roth IRA.
For 2022 and filing as a single income tax filer, the income limit is $129,000. Once you cross $129,000 the amount you can invest is reduced until you become ineligible at the $140,000 income threshold.
For married filing jointly, contribution allowances start to decrease at $204,000 and disappear at $214,000.
Like a traditional IRA, you can open a Roth IRA account through a bank, brokerage, or an IRA provider. Note that some firms require a minimum investment amount to open an account, so you’ll want to do a little research beforehand to compare your options
A tax loophole worth mentioning is the Backdoor IRA.
I talked about it exclusively here:
The Backdoor IRA is a way for those whose income exceeds the income limitations put in place by the IRS to still contribute to a Roth IRA. This is its main benefit.
It involves converting a traditional IRA into a Roth variety. When money is converted over from a traditional to Roth IRA, taxes are owed at the end of the tax year that the conversion occurs in.
The good part about this strategy is that once converted to a Roth no other taxes are owed for as long as the Roth IRA exists. Also, any growth in the Roth IRA is tax-free and is tax-free upon withdrawal during retirement.
This is NOT a tax dodge. It is a tax-code loophole that people have been using for years and is definitely worth checking out.
Self-Employed (SEP) IRA
SEP IRAs are for self-employed people or small business owners with few or even no employees. Like traditional IRA’s, the contributions are tax-deductible, and investments grow tax-deferred until retirement when distributions are taxed as income.
There is no Roth option either.
In 2022, a person can contribute either 25% of their total compensation or $61,0000 whichever is less.
On the downside, there is no catchup contributions allowed for people age 50+ and SEP IRAs required a minimum distribution (RMD) beginning at age 72.
Lastly as a business owner, you can make pre-tax contributions for yourself, but there is a caveat.
The IRA states that employers must also contribute the same percentage on behalf of all eligible employees.
Setting up a SEP IRA is pretty simple too. Start by filling out and filing IRS Form 5305-SEP. You don’t have to send this form directly to the IRS. You also have the option to use a broker like Fidelity or Vanguard to sign up and provide the form for you.
Simple IRA
Savings Incentive Match Plan for Employees (SIMPLE) IRAs are for small businesses with fewer than 100 employees. Like traditional IRA’s, the contributions are tax-deductible and grow tax-deferred until retirement when distributions are taxed as income.
Like 401K’s, eligible employees indicate how much (if anything) of each paycheck they want to contribute, and the money is automatically diverted into the worker’s individual investment account.
In 2022, employee contributions limits are $14,000 per year for those under age 50 and $17,000 for those over the age of 50.
Lastly, employer contributions are mandatory with a SIMPLE IRA.
Opening a SIMPLE IRA is easy and similar to opening a traditional IRA. However, there are additional steps / reporting requirements that must be filled out to establish the plan.
To get started, pick the type of SIMPLE IRA plan you want to use by filling out either an IRS Form 5305-SIMPLE (if depositing contributions at a designated financial institution) or 5304-SIMPLE (if employees are permitted to choose a financial institution for the account).
Next, provide any eligible employees information about the SIMPLE IRA plan.
Lastly, set up SIMPLE IRAs for each eligible employee using IRS Form 5305-S or 5305-SA.
Self-Directed IRA
Self-Directed IRA’s give an investor more control of the investments chosen and enables a broader investment diversification that what is allowed with traditional / Roth IRA’s. With traditional or Roth IRA’s, you are limited to investing in stocks, bonds, mutual funds, and ETF’s.
Not so with a self-directed IRA.
With a self-directed IRA, you can invest in a plethora of alternative assets such as real estate purchases, real estate crowdfunding, property liens, precious metals, cryptocurrency, small business investing, P2P loans, and so much more.
The main caveat is that you need a custodian or trustee to hold the account for you.
This type of IRA is for investors seeking exposure to a broad universe of asset classes and are looking for potential non-correlated returns, exposure to private investing, and investments not related to the stock market.
For example, instead of just investing in a REIT or stock related to real estate, you can invest in a property on a tax lien and purchase it for pennies on the dollar. Once the back taxes are paid in full, you can re-sell the property at market value and keep the profits inside the self-directed IRA! Rinse and repeat and watch the fund grow! 😊
On top of that, a self-directed IRA can be created either as a traditional IRA (pre-tax money out in and taxed at distribution) or Roth IRA (invest after-tax money and is tax-free at distribution).
Choices are a good thing!
To get started, you’ll need to find a custodian for the account, a great place to look for one is Investopedia.
Here is an article to get started with:
Best Self-Directed IRA Companies
Where To Go From Here
Today we covered a lot of ground in the world of IRA’s.
There are a ton of choices to pick from.
The first thing I recommend doing is to understand what you want from your IRA. Are you looking for a tax-free investment? Do you want to invest in alternative investments? Do you have a business and want to maximize your retirement investments?
Once you decide on what you are looking for, decide on what investments you want to diversify into and then go from there.
IRA’s are a great tool to use under the right circumstances and the right situation.
I hope this article gets you started on the right track……
Live The Life You Love, Want, And Deserve! 😊
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