If you are planning to save for your retirement, then investing in IRA (Individual Retirement Accounts) can provide significant tax advantages. You may be aware that in a taxable investment account, you have to pay annual taxes for any profits that you have earned, and it can slow the benefit of that account. In this scenario, so what is IRA? It’s an excellent instrument to set aside money for old-age financial security. To find out what is IRA in-depth, continue reading.
What is an Individual Retirement Account? (IRA)
Individual Retirement Account (IRA) is a type of retirement plan for individuals and small business owners with tax benefits. Simply put about what is IRA- the meaning of IRA is a personal savings account that allows you to save money upfront for your retirement. You can contribute each year up to the maximum amount allowed by the Internal Revenue Service (IRS).
You can set up an IRA with any financial institution or bank, stockbroker, mutual fund, and life insurance company. Investing in IRAs comes with different options including, traditional IRAs and Roth IRAs.
Types of IRA
Traditional IRA?
A traditional IRA is a tax-deferred personal savings account where you won’t be paying taxes now but at the time of withdrawal of the retirement money. When one says deferred, it means all your interests, dividends, and capital gains will reap the benefits of compounding without being nipped by taxes like in a taxable account. It will allow your IRA to grow much faster.
Roth IRA?
A Roth IRA is a tax-advantaged personal savings account where you save money after paying taxes. So, choosing a Roth account means getting a tax break later. It means your lump sum corpus would be tax-free at the time of retirement. However, you can only take the earnings out of a Roth IRA after the age of 59 and ½ years, and after owning the account for a minimum period of five years. Withdrawing that money earlier can trigger taxes and a 10% early withdrawal penalty.
Similarities and Differences Between Traditional IRA and Roth IRA
Now that we know what is IRA, let us find out how Traditional and Roth IRAs are vehicles for saving money on retirement. Both schemes allow you to save for the future to help you bear the financial costs in absence of an active stream of income. This chart highlights their similarities and differences.
| Features | Traditional | Roth |
| Who is eligible to contribute to an IRA? | Anyone is free to contribute to a traditional IRA if the beneficiary (this includes your spouse in a joint filing) is in the receipt of taxable compensation. Before January 1, 2020, applicants older than the age of 70 and ½ years were unable to contribute to the IRAs. | Contribution to a Roth IRA is possible at any age. You must have taxable compensation. Also, your modified adjusted gross income must be below the regulated cut-off. (Refer to 2021 and 2022 limits for clarity on eligibility.) |
| How much can someone contribute to an IRA account? | Your contribution to the IRAs is smaller than – $6,000, or $7,000 if you’re 50 or older by the yearend (For 2020); oryour taxable compensation for the year.$6,000, or $7,000 if you’re 50 or older by the yearend (For 2021); oryour taxable compensation for the year.$6,000, or $7,000 if you’re 50 or older by the yearend (For 2022); oryour taxable compensation for the year. | |
| Is there any deadline for the aforesaid contributions? | If you are investing in IRA, The deadline is the same as the one assigned to you for your tax return filing. The deadline is independent of the extensions offered in tax filing. | |
| When can the money invested be withdrawn? | Irrespective of the type of IRA account, one can withdraw money anytime. | |
| Are withdrawals from the IRA taxable? | If you know what a traditional IRA is, any earnings you withdraw or funds that are distributed from your account, are liable to be taxed. | Roth IRA does not attract taxation as it has been already paid for. While investing in IRA remember that if it’s a qualified distribution or withdrawal, there is no tax. |
Key Takeaways
- With a Roth IRA, the meaning of IRA changes in light of the tax burden. You save money upon taxation in a Roth IRA; hence, you enjoy a tax break at the time of its withdrawal.
- Withdrawing money from the IRA, whether traditional or Roth before you cross the milestone of 59 and a ½ years, can attract taxes. Barring some exceptions, you will also be slapped with a 10% penalty for early withdrawal.
- Investing in IRAs depends on your circumstances, your age and your income.
- The deciding factor in choosing an IRA depends on whether your tax rate during retirement would be higher or lower than during the years you would be contributing to it.
- To combat future uncertainties, advisors recommend diversifying the IRA investment portfolio.
- Investment in IRA varies depending on your risk capacity as well. Those with a higher risk appetite and disposable income have more elbow room to make a diverse portfolio.
Benefits of IRA
Here are the major benefits of IRA-
- Growth Without Paying Taxes:
What this means is, once the money is received on the account, no taxes can be levied on that particular amount. This saves a lot of money for the client as the tax deduction does not take place in IRA.
- Liquid and Flexible
Investors have an option to make withdrawals early (before the age of 59.5), without paying for any additional charges. There is also an option the withdraw a large sum to buy a new house (upto $10,000). Now we know what is IRA and its core benefits.
How Do I Start Investing in IRA?
The deciding factor in choosing an IRA plan would be whether your tax rate at the time of retirement is higher or lower than during the years you would be contributing to it. While investing in IRA, if your tax rate is going to be higher during the years you would be contributing, then opting for a traditional IRA may be better.
For example, if you are married, have a mortgage and paying for kids’ college, then you may want to opt for a traditional IRA. In this scenario, by the time you retire you have paid for the mortgage and college fee and your income would be lower. So, your tax rate would be lower on the retirement money.
However, if you think your tax rate may be higher at the age of retirement, then choosing a Roth IRA over investing in IRA that is traditional, makes sense. Let’s assume that you are an investor starting young in your career. You may expect to pay higher taxes later in your career and at the time of retirement. The meaning of IRA savings changes for you. By choosing to pay taxes now at a lower tax rate you may benefit by paying less than you would end up after retirement. You will not have to worry about taxes also, as your retirement money would be completely tax-free in Roth IRA.
Though the above examples sound good in theory. Nobody can predict the future. Hence, some financial advisors suggest diversifying the investment by opening both accounts – traditional and Roth IRAs.
There are other avenues to secure your future post-retirement. You can invest in mutual funds, individual stocks, government bonds and annuities. Certain real estate investments can also yield substantial gains that can make you future-ready. Again, there are exceptions outlined by IRS. For instance, you cannot lend yourself money by investing in IRA. There are other safeguards against exploiting IRA savings. Using money invested in IRA as collateral for a loan is prohibited. You cannot park IRA savings to pick up real estate for personal use.
When to Start Investing in IRA?
To answer what is IRA account, and when you should start investing- you can put up to $6,000 a year and can contribute even more if you are 50 years or older. Other tools in your kitty are savings, investments and a 401(k) plan. The graph here shows how early retirement planning would benefit you.
What Investments Accounts Should you Use?
Most investors who are beginning their investment journey go for a cash account. It is the most appropriate option for the investors as it helps the investors to make investments through cash method. Mostly, broker plays a role in cash investors which makes the process easier for the investor and easy to buy investments.
Conclusion
The most tangible benefit of investing in IRAs is that in this account your earnings aren’t taxed while they are in the account, which helps your investments compound. Over time, compound interest and tax deferrals make a big difference in the amount you will accumulate. So, what is IRA? IRA can be a great help to people who do not have a regular stream of income post-retirement.
Access your retirement needs and take advantage of all financial instruments available to make your golden years comfortable and financially secure. According to statistics, an average American spends roughly 20 years in retirement. So, it is always advisable to start investing in an IRA early. This was our in-depth article about what is IRA, and it is always a better option to invest to make a safer future financially. So, start investing now!
Frequently Asked Questions
You can open an IRA at any age as long as you have earned income. Minors need an adult to serve as their custodian.
In your IRA account, you can put up to $6,000 a year and can contribute up to $7,000 if you are 50 or older.
Once you know what is Individual Retirement Account, you can open an IRA with banks, mutual fund companies, brokerage firms, and life insurance companies.
You can withdraw money from IRA before retirement but it will attract a tax penalty of 10 per cent.
There are a few exceptions. Withdrawal to pay for college fees, buying your first home (up to $10,000), and meeting medical expenses, does not attract taxes.
Yes, IRAs earn an average of 7-10% interest annually.
An average of 7-10% returns annually.
If you are looking for short-term savings plan, then savings account will work best. For investors seeking long term stability, IRA is preferable.
80% of your final income (annual) pre-retirement is the ideal time according to the experts.
