L Bee Note: Today's post is by Anum Yoon who writes over at Current On Currency. Her last post was so popular, I couldn't say no to another piece. I get tons of questions about IRA's so I hope this answers a few.
Even though the tax code is tens of thousands of pages long and way too complicated for many Americans to understand, it still offers benefits to the average American taxpayer. One of those benefits is the Individual Retirement Account (IRA).
The concept of an IRA is based on a provision in the tax code that allows you to save for retirement with certain tax advantages. You want to be able to preserve as much of your wealth as possible, so when you’re ready to celebrate your sunset years you can do so with vacations and fun novelties.
There are several ways you can open an IRA account. Try contacting your local bank, a mutual fund company or an online brokerage.
When you decide to create an IRA account, you should know there are two types of IRAs to choose from: Roth and traditional IRAs.
Everything You Need to Know about IRAs
- Traditional IRA – Your tax burden is reduced while you contribute to the account, but you’ll pay taxes when you withdraw money during retirement.
- Roth IRA – You put after-tax money into your account. You won’t pay taxes when you withdraw money from the account later.
If you’d prefer to pay as much of your taxes during your working years as possible and have peace of mind knowing that Uncle Sam will take a smaller tax bite out of your income later on in life, you should opt for a Roth IRA.
On the other hand, if you need money for income now and would like to take advantage of the tax code to make contributions to your retirement account, select a traditional IRA. You'll need a brokerage account first. Click here to open a TradeKing IRA account. It's just $1 to start!
Here’s what you need to know about IRAs:
The sky is not the limit
You can’t make endless contributions to your retirement account in an effort to amass a fortune when you’re ready for retirement. There are limits to how much you can contribute.
You can contribute as much as $5,500 per year to a retirement account while you’re under the age of 50. After that, you can contribute as much as $6,500 per year to the account.
Although your IRA portfolio will grow tax-free, the amount of money that you can deduct from your taxes depends on couple of other factors, such as your tax bracket and whether you have a retirement plan at work.
This year, you lose the tax advantage for a traditional IRA once your income reaches between $61,000 and $71,000 if you’re filing single. If you file joint, you lose the deduction once your income reaches between $98,000 and $118,000.
For a Roth IRA, you lose the deduction once your income reaches between $116,000 and $131,000 (single) or $183,000 and $193,000 (joint).
You can contribute to both a 401(k) and an IRA at the same time
You may work for a company that offers a 401(k). That benefit will not only offer you certain tax advantages similar to an IRA, but you might also get a bonus if you’re employer matches your contributions.
A 401(k) account places an annual limit on how much you can contribute. So if you’ve maxed out your 401(k), you can still contribute to an IRA.
Withdraw early, pay a fine
Even though the money in a traditional retirement account is technically yours, you’re not supposed to withdraw it prior to retirement. The IRS will assess a penalty if you do so.
As of this writing, you’ll pay taxes on the withdrawal amount based on your tax bracket plus an additional 10%. For example, if your tax bracket is 35%, you’ll pay almost half (35% + 10%) of your withdrawal in taxes.
This is why many financial advisors tell their clients to have about 3-6 months’ worth of expenses in the bank. That way, they’re not tempted to withdraw money from their retirement accounts.
Roth IRAs operate a little differently, though. If you withdraw money from a Roth IRA, you won’t be subject to a penalty because you’ve already paid taxes on the money you contributed to the account.
Federal law allows you to put aside money for retirement in a way that offers tax advantages. Be sure to talk to your financial planner and select the plan that will best prepare you for your golden years.
For more tips on how to save better, click here.
Anum Yoon is a recovering bubble tea addict, currently coping with said problem by channeling her energy into personal finance writing. She almost always has a cup of tea or coffee in her hand, and when she’s not talking about money management, she’s cooking up some Korean food in her kitchen.