Retirement is bound to come no matter how young you are and the sooner you start planning for it the better. An IRA is an account that you set up for this purpose. It’s an investing tool that has some tax advantages attached to it. People create IRAs to plan for the inevitable retirement age where they’ll still need money.
IRAs hold a host on investments and the more diversified the better. You can opt to invest in mutual funds, shares, options, EFTs among others. There are different types of IRAs that you must know as you set out to start planning for your retirement. They include:
- Roth IRAs
- Traditional IRAs
- SIMPLE IRAs
- SEP IRAs
When it comes to IRAs, you can opt to manage them or have a financial advisor or broker do it. For those that you manage, you can have a Roth IRA or a Traditional IRA. Here, you are in charge of all the decisions including what investments to place money on. An IRA that you manage is a wise choice for you to get access to a wider variety of investment products. If you are employed, the ROTH or Traditional IRA is a better choice when it comes to setting up an IRA.
For those who are self-employed and even own businesses, the best choice for IRA is SIMPLE and SEP. This secures your financial future and helps you start planning for it, now. Choose a bank that is authorized by the IRS (Internal Revenue Service) to open IRAs. Other places you can set up IRAs are brokerage firms, savings & loan institutions, and credit unions.
IRAs have certain rules that you must keep in mind as you set out to open one. The money you use to open this account must be income that you’ve earned. Disregard any other form of income as most including child support, alimony, and investment income are not allowed. Types of earned income that you can use to set up IRAs are:
- Taxable compensation received by employees such as salary, tips, and wages.
- Benefits from union strikes
- Income received from running a business
- Benefits received after early retirement due to disability
Once you decide to open an IRA, be ready to wait before cashing it in and the limit age set is 59.5 years. In case you cash it in sooner than that, a penalty of 10% applies. Early withdrawal also attracts an income tax but depends on the type of IRA you have.
It is worth noting, a change in this rule due to the Coronavirus pandemic currently affecting the world. Under the CARE ACT, anyone affected by this pandemic is permitted to cash in their 401 (k) and other IRAs up to $100000 with reduced limitations and consequences. With this new Act, the 10% penalty is waived in the year 2020 and no withholding requirements are attached.
Types of IRAs
There are four main types of IRAs: ROTH IRAs, Traditional IRAs, SIMPLE IRAs, and SEP IRAs.
a) ROTH IRAs
With a Roth IRA, you shouldn’t worry about any taxation once the time comes to withdraw your savings. It’s a tax exempted account which is good news to everyone. The investment is named after William Roth who was a US senator back in 1997. The contributions you make on a Roth IRA are not tax-deductible and are funded by after-tax dollars. In case you have a feeling the taxes that come after you retire will be higher, then it’s advisable to opt for this type of IRA.
One point to note, there is a clear definition of who can contribute to the Roth IRA. You can’t contribute to it if you are a high-income earner. The limit set for couples is $206,000 annual income and singles $139,000. Keep in mind that the amount that you contribute is susceptible to annual changes. You can open a Roth IRA in all institutions including banks that are allowed to offer IRAs by the IRS.
For as long as you are earning an income, you can keep contributing to your Roth IRA as it’s less restrictive. You can opt to keep the account after the retirement age of 50.5 years and not cash it in in case you keep earning an income after this. Contribute regularly to the Roth account and this can be done by establishing regular contributions or creating spousal IRA contributions. Other options are Rollover, Transfers, and Conversions.
Once you’ve set up the Roth IRA and deposited money into it, you can opt to invest in several products. There are shares, mutual funds, options among others. Keep in mind there is a set limit by the IRS on how much you can contribute to your Roth IRA. For the year 2020, the limit is set at $6,000 for an individual. Anyone above the age of 50 makes an annual contribution of $7,000.
Opening the Roth IRA
Ensure the institution is authorized by the IRS to provide this type of account. You can set this account at any time but keep in mind contributions must hit the account before the deadline of filing taxes. You can’t make a contribution during the extended time of filing taxes. Once you’ve set up the account, ensure the institution provides you with the IRA Disclosure Statement. Another important document you must receive is the IRA Adoption Agreement and Plan Document.
As you consider which institution to open this account with, think through what your plans for it are. Do you intend to invest in a variety of investment products? If this is your intention, then seek out an institution with a variety of these products. Some have impressive selections available to their clients. Keep in mind there are certain fees that apply to your Roth account and they vary from one institution to another.
Seek institutions that have lower trading costs if your plan is to be actively involved in investing. This ensures the amount of money in your account isn’t impacted by additional costs and fees. It’s prudent to look into additional rules and regulations such as inactivity fees in case you don’t maintain active trading on your IRA. Each institution has rules that apply to this account that you must understand in detail.
Pros of Roth IRA
1. Tax-Free savings
Since you pay the income tax, then contributions to this IRA are exempted from further taxation. You can withdraw all your money once you reach 59.5 years or keep contributing to the account.
2. No age Limit
Once you pass the retirement age of 59.5 years, you can continue contributing to the IRA indefinitely. Traditional IRAs force you to withdraw funds at 72 years due to taxes.
Cons of Roth IRAs
With this IRA, you contribute to it once you’ve paid income tax.
2. Maximum Contribution
The maximum contribution for this IRA is low set at $6,000 only.
b) Traditional IRAs
When you decide to open a traditional IRA, you will be directing pre-tax income to it. The income is used for various investments. The time you get to remit tax in this account is when you request a withdrawal and the IRS comes calling. You have the option of channeling all your income into this account but keep in mind there is a limit to the amount allowed. You can open this account through your financial advisor or brokerage firm.
The age where you permitted to make penalty-free withdrawal from the Traditional IRA is set at 59.5. It’s at this time the amount will be taxed according to your current tax rate. Once you open this account, be an active investor and guide the institution on the investment products to direct the money into. All contributions to this account are tax-deductible. The common contribution for individuals under 50 is $6,000 annually. You can claim this as a deductible in your income tax return.
The more advanced in age you become, the more restrictive the IRS is on how much you can contribute to the IRA. Anyone above the age of 50 is required to contribute $7,000 annually. Anyone who is under an employer’s retirement plan and has a traditional IRA has further restrictions on deductible tax. Ensure you have contributed to your Traditional IRA before the deadline for filing taxes. Any money received as distribution is subjected to income tax by the IRS.
It simply means you should pay income tax on the money in your IRA account once you turn 59.5 years old and opt to withdraw funds. Some people opt not to withdraw the money from this account and extend it if they have continuous income. When this happens, once you reach 72 years old, you must take distributions in what is regarded as RMD (Required Minimum Distribution). This is a new rule as of 2020 under the SECURE Act.
Even for this IRA, early withdrawal warrants a penalty of 10% and income tax rates apply as well. However, the Traditional IRA has exemptions to these conditions for early withdrawal
- Homeownership. Buying or repairing your first home
- Asset distribution to a beneficiary after your death
- Active military duty that exceeds 179 days
- To cover medical expenses that are not reimbursed
- Covering higher education tuition and expenses
- Cover expenses for adopting a child
- Cover medical insurance after becoming unemployed
Opening a Traditional IRA
It’s not as hard to open an IRA as you might think considering all the information you must know. It’s better to set up a traditional IRA as early in life as possible. Later in life, you will be thankful you took this step for your financial future. An important point to remember is to open this account in an institution authorized by the IRA. Some of these institutions include banks, credit unions, and brokerage firms among others.
It’s simple to set up a Traditional IRA online with only a few steps. Most discount online brokerage firms offer this service to their clients. Choose the one that appeals to you and offers most of the investment products you have an interest in. This way, you have a better say on where your funds are invested and can change the options at any point.
Pros of Traditional IRAs
You can file the Traditional IRA for a tax deduction. It’s advisable to set up if you know you will pay less tax once you retire.
2. Available to all
Anyone can set up a Traditional Ira but must keep in mind the limit for contribution set at $6,000 annually.
Cons of Traditional IRAs
Once you hit the retirement age and want to withdraw from this IRA, you must pay taxes. In case you continue with the contribution, you must withdraw at 72 years for the tax to apply.
2. Low Annual Contributions
You can only contribute $6,000 per year. Even if you can contribute more, this IRA is not flexible to permit this.
c) SIMPLE (Savings Incentive Match Plan Employees) IRA
The IRA is suited for small businesses that have less than 100 employees on their payroll. Employers have the option of setting up a retirement account for their employees of up to 2% or can opt to match it with 3%. The maximum contribution allowed per employee is $13,500 as per the increasing inflation rate. This amount changes each year. For employees above 50 years, they contribute $16,500 annually.
An employer who wants to establish a SIMPLE IRA should do so in a reputable and authorized financial institution. The employee gets to fill in minimal documentation and get disclosures each year of the account activity. Any employer that makes such contributions for their employers is awarded certain tax deductions. The account is easy to maintain and incurs minimal costs. Ensure you have less than 100 employees on your payroll before you can set up the SIMPLE IRA.
Setting up a SIMPLE IRA
When an employer decides to establish this IRA for their employees they should fill out Form 5304 or 5305 provided by the IRS. Form 5304 applies when employees are allowed to choose a financial institution where the SIMPLE IRA will be held. Form 5305 is when the employer gets to choose for them. Each employee is required to fill out an Adoption Agreement for the SIMPLE IRA as per the law.
All through, employees are supposed to contribute to this account annually unless it’s terminated for one reason or the other. It is not the best IRA plan for employers and their employees because there is a limit to the contribution amount. There is a two year waiting period in case you want to roll over the SIMPLE IRA into a Traditional IRA.
d) SEP (Simplified Employee Pension) IRA
The SEP IRA is established by those who are self-employed or an employer. In the case of an employer, they qualify for a tax deduction when they contribute to the SEP IRA. The good part of this type of IRA is the high limit for contribution, meaning you can opt to put in more. Most employers prefer SEP IRA for their employees because it has a simplified establishment process. When joining the SEP plan, an employee must be above the age of 21 and have been employed for more than three years.
The employer is allowed not to make contributions in the years that business is low. For the SEP, tax rules that apply are similar to those in the Traditional IRAs. Investment products accessible to this IRA are also similar. The employer is permitted to make changes to contributions annually. They also receive tax deductions for the contributions made to the SEP IRA.
Once the IRA is established, it’s the obligation of the appointed trustee to determine the best investments to make. This way, the employer is free to keep the focus on the business. When an employee is placed in their employer’s SEP, they must set up their Traditional IRA as well. Where the employer will deposit their SEP contributions.
Even though the SEP is to encourage more businesses to save for their employees, those who earn high income are not eligible. The limit for contribution is set at $285,000. Not all employees are covered in the SEP IRA which is a fact any employee needs to be aware of. Those who are under union retirement benefits are one group of employees excluded from SEPs. Any early withdrawal is still susceptible to the rules of IRAs including the 10% penalty and taxes.
Before you can establish an IRA as an individual or employer, get to understand what it is and which types are available. By doing this, you can pick out which one is the best to use depending on taxation, contribution and other important features.