An IRA (Individual Retirement Arrangement) is a retirement account you can use if you have earned income that offers tax benefits.
The basic idea is that you place your own money into an IRA account and use the money later in life during retirement. Once invested, the money you place in the account will earn interest, dividends, and capital gains (investments will grow in value).
There are different types of IRAs available. In general, these include Roth IRAs, Traditional IRAs, SIMPLE IRAs, and SEP (Simplified Employee Pension) IRAs.
IRA Contribution Limits
Contribution Limits are $6,000/year (or up to $7,000/year once you turn 50 years old). If you earn less than $6,000 during the year, you can only contribute up to the amount you earned. For example, if you earned $2,600 during the year, then that is your max contribution allowed since you can only contribute income that you earned. This is mostly relevant for younger individuals who work summer jobs or for part-time workers.
Although you can open more than one IRA, you cannot exceed the maximum contributions to all accounts when you add up all contributions.
For example, if you have three Traditional IRAs and one Roth IRA, and have earned more than $6,000 during the year, your max contribution between all four IRAs cannot exceed $6,000.
If you exceed the contribution limits for a given year, you must report it and pay a 6% tax for excess contributions.
Let’s begin by taking a look at the original IRA (aka Traditional IRA). Then let’s move to the Roth IRA, our personal favorite. These two IRAs are the two you should become familiar with first.
The difference between a Traditional IRA and Roth IRA is that the money you put INTO a Traditional IRA is taxed when it is withdrawn (during your retirement). This is because your contributions count as a tax deduction.
Anyone can open a Traditional IRA as long as you earned income during the year and are less than 70 and ½ years old. They are usually opened at a bank or other financial institution. We think doing it online is the easiest route.
Contributions, interest, dividends, and capital gains in Traditional IRAs are not taxed IN the year earned but are taxed when the money is withdrawn from the account. Once the money is withdrawn, it is taxed as ordinary income.
Withdrawals from a Traditional IRA can be done at any time. However, a 10% additional tax will apply if you withdraw your money prior to turning 59 and ½ years old (unless you qualify for exceptions).
Contributions To A Traditional IRA Are Tax-Deductible
One of the unique features of the Traditional IRA is that you can deduct contributions from your income for tax purposes, based on filing status, income, and other available retirement accounts.
This tax deduction means that you will defer taxes on your traditional IRA until you retire! You can deduct 100% of your Traditional IRA contributions when you file taxes as long as you are not covered by an employer-sponsored retirement plan at work (pro tip: look at your W-2 for the year and make sure the “Retirement plan” box is not checked).
2020 Traditional IRA Deduction Limits
If the box is not checked (meaning you are NOT covered by a retirement plan at work), then you can use the deduction guides below.
If your filing status is:
- Single, head of household, or qualifying widow(er), then you can take a full deduction up to your contribution limit.
- Married filing jointly or separately with a spouse who is not covered by a plan at work, then you can take a full deduction up to your contribution limit.
- Married filing jointly with a spouse who is covered by a plan at work, and your Modified AGI is:
- $196,000 or less, then you can take a full deduction up to your contribution limit.
- more than $196,000 but less than $206,000, then you can take a partial deduction.
- $206,000 or more, then you cannot take a deduction.
If the “Retirement plan” box is checked on your W-2 is checked, then your deduction depends on your filing status and income.
If your filing status is:
- Single or head of household, and your Modified AGI is:
- $65,000 or less, then you can take a full deduction up to your contribution limit.
- more than $65,000 but less than $75,000, then you can take a partial deduction.
- $75,000 or more, then you cannot take a deduction.
- Married filing jointly or qualifying widow(er), and your Modified AGI is:
- $104,000 or less, then you can take a full deduction up to your contribution limit.
- more than $104,000 but less than $124,000, then you can take a partial deduction.
- $124,000 or more, then you cannot take a deduction.
- Married filing separately, and your Modified AGI is:
- Less than $10,000, then you can take a partial deduction.
- $10,000 or more, then you cannot take a deduction.
Note: If you file separately and did not live with your spouse at any time during the year, your Traditional IRA deduction is determined under the “single” filing status.
Roth IRAs are similar to Traditional IRAs, but there are some important differences. The first is that a Roth IRA contribution is made with AFTER-TAX dollars. You don’t get a tax deduction up-front like with a traditional IRA.
However, unlike Traditional IRAs, Roth IRAs can be withdrawn tax-free after age 59 ½.
Additionally, you can withdraw your contributions (ONLY the total you contributed, NOT any of the investment gains) at any time, tax and penalty-free!
This is a game-changer because your money isn’t necessarily trapped until you retire. Ideally, you won’t touch it until retirement, but it’s nice to know you can access it, penalty-free, in case of an emergency.
If you take an early distribution of the investment gains, you will be subject to the 10% penalty. There are also exceptions to withdrawing money prior to turning 59 ½, so be sure to make sure you qualify before you withdraw any money.
Contributions To A Roth IRA Are NOT Tax-Deductible
Sounds pretty great, right? You’re probably wondering what the catch is. One is that you cannot deduct contributions made to a Roth IRA on your taxes.
The 2nd catch is that there is an income limit to contribute to a Roth IRA. You can contribute towards a Roth IRA as long as your income is NOT above a certain threshold based on filing status.
For those filing as single or head of household, you can make a full contribution ($6,000 or $7,000 if 50+ years old) if your modified AGI (adjusted gross income) is less than $122,000. You can make a partial contribution up until your modified AGI hits $137,000 at which point you are no longer eligible to contribute to a Roth IRA.
For most of us, this income limit isn’t that relevant, but important to be aware of!
Other Types Of IRAs
What Is A SIMPLE IRA?
SIMPLE IRAs (Savings Incentive Match Plan for Employees of Small Employers) are used by small employers and companies. If the small business you work for uses SIMPLE IRAs you can still contribute to your own Traditional IRA or Roth IRA.
What Is A SEP IRA?
SEP IRAs (Simplified Employee Pension) allow employers to contribute money to their employees’ retirement via a Traditional IRA! Employer SEP IRA contributions do not count towards your own Traditional or Roth IRA yearly contribution limit. Few companies do this, but it’s good to be aware of it.
Roth IRA vs. traditional IRA – which should you choose?
Before we begin, it’s important to realize that in general, the biggest difference between a Roth IRA and a Traditional IRA, is simply the timing of the tax benefits.
So, which one is better between Roth IRA vs Traditional IRA?
Short answer: Since I still have many years of working and my best earning years ahead of me, I primarily fund a Roth IRA. I also like that the Roth IRA allows me to withdraw my contributions penalty-free at any time without having to worry about exceptions.
Long answer: It depends. If you expect to earn a higher income in the future, you may jump into a higher tax bracket. In that case, putting your money into a Roth IRA now might make more sense.
Since you are currently in a lower tax bracket why not pay the taxes now (at the lower rate) so you can use take the money out tax-free once you are in the higher tax bracket (and avoid paying that higher tax).
On the other hand, if you are in your top earning years, you can put the money into a Traditional IRA since you will likely be in a lower tax bracket during retirement.
At the end of the day, predicting future tax brackets is impossible.
What do you need to open a traditional IRA account?
Opening an IRA account is easy!
You will need to set up your IRA in a brokerage account. Many large banks can help you set up a brokerage account, but we recommend going with a discount online brokerage for one main reason: fewer fees.
When you’re first getting started, you simply do not have that much money. By minimizing the amount of money you pay the brokerage firm (in fees), the more you are investing in the account. There are many such companies out there, which we will cover below.
Remember, by managing your own account (with low fees), you get to keep more of what your investment earns. If the market goes up by 8%, you should get as much of that as possible. You not only deserve it, but you have also EARNED it! If you pay someone a 2% management fee, you will only get 6%.
With that said, some people would gladly pay a little bit of money to have a professional help them. That is totally understandable, and we recommend you check out Facet Wealth, a trusted online financial planning company.
If you are ready to open an IRA, read our step-by-step guide on opening IRAs.
Where can I get an IRA?
There are many options including Charles Schwab, E-Trade, Fidelity, and Scottrade. However, Vanguard and Fidelity are our favorites because of their low-cost index funds. In case you are wondering, this post wasn’t sponsored by anyone, and we are not making money by recommending Vanguard or Fidelity. We just think they have a great product!
The minimum amount needed to open a Roth IRA with Vanguard is $1,000 dollars, but many of their funds have a $3,000 minimum investment requirement. One of the popular funds they offer that you can choose to invest in is the “Vanguard Target Retirement Funds” ($1,000 minimum).
Fidelity doesn’t have an account minimum and offers a free no-fee index fund under the ticker FZROX. Fidelity also offers target-date funds.
We love these funds because they are diversified portfolios that change over time, based on your target retirement year, making it easy to manage because they handle all of your asset allocations for you! The further you are from your retirement the more risk you should take to maximize your retirement account.
Is It Hard To Manage An IRA?
One easy way to diversify your portfolio is by owning the entire stock market.
Owning the entire stock market? It may sound impossible, but by putting your investments in index funds (like an S&P 500 index fund), you are guaranteed to get the same return of the entire stock market. This is because an index fund is an investment made up of small shares of a large number of other investments.
Historically, this has been a winning strategy. The market may go up and down, but over extended periods of time, it has always gone up!
If you’re ready to get started, head over to Vanguard: www.vanguard.com or Fidelity: www.fidelity.com. Reminder: Vanguard and Fidelity did NOT elicit this recommendation and we do not profit if you choose to invest with them. Not a single buck.
Excess Roth IRA Contributions
As we learned earlier, IRAs have contribution limits as well as income limits. So what happens if you contribute too much or your income is too high for a Roth IRA?
If you violate any IRA contribution rules, you’ll owe the IRS a 6% annual penalty on the amount until you fix your error.
Generally, an excess contribution is the amount contributed to your traditional IRAs for the year that is more than the smaller of:
- $6,000 ($7,000 if you are age 50 or older), or
- Your taxable compensation for the year.
Contributions for the year you reach age 70 1/2 and any later year are also excess contributions.
The IRS says that “An excess contribution could be the result of your contribution, your spouse’s contribution, your employer’s contribution, or an improper rollover contribution.”
The good news is that if you catch the error prior to the date your tax return is due, you can withdraw excess contributions to avoid the penalty.
However, if you need to fix an error from a previous year, you’ll have to do it a bit differently:
- Remove the excess within 6 months and file an amended return by October 15—if eligible, the excess plus your earnings can be removed by this date.
- Remove the excess once discovered, even after October 15. You’ll need to reduce next year’s contributions by the amount of the excess. For example, if your limit is $6,000 and you exceed it by $1,500 in the current year, you can offset the excess by limiting your contributions to $4,500 the following year.
If you have made an excess IRA contribution and are unsure of what to do, you can check the IRS’ Publication 590A for more details.
I Should Have Opened A Roth IRA Sooner
Let’s be honest here. When I first started my career, I had absolutely NO idea what a Traditional IRA or a Roth IRA was. Not even the slightest clue. I vaguely knew it was a ‘retirement thing’.
Not having a Roth IRA sooner is one of the money mistakes I’ve made. And maybe you made the same mistake, but that’s okay. It’s not too late.
My twin brother spent the majority of his 20’s in school. I, however, started working in NYC when I was 22 years old.
Unfortunately, with no one to teach me about personal finance, I didn’t realize I should have opened a Roth IRA for several years. I finally opened a Roth IRA at age 25, which is still awesome. But it would’ve been a big help to have opened it earlier.
The reason it’s important to open an IRA now is that when investing over a long time horizon, the amount of time you invest is INCREDIBLY important. Maybe even more important than the amount of money that you invest. Now that I spent the time to learn the ins and outs of IRAs, I contribute to mine regularly and have never looked back. I encourage you to do the same.
IRA stands for Individual Retirement Arrangement, and it is a retirement account that offers tax benefits to incentivize American workers to save for retirement.
Yes, but you only avoid the 6% penalty if you do it before your tax return is due.
You are allowed to make qualified withdrawals from a traditional IRA at age 59 1/2. You are required to start taking minimum distributions in the year in which you turn 70 1/2.
The biggest difference between the two is the timing of the tax benefit. Traditional IRAs give you a tax break in the year you contribute, while Roth IRAs save the benefit for retirement. If you expect to have a higher tax rates in retirement, go with a Roth IRA or vice-versa.
Camilo is a personal finance expert and the Co-Founder and CEO of The Finance Twins. I was raised in poverty by a single mother and had to learn everything about personal finance on my own. I have been featured on Forbes, Business Insider, CNBC, and US News. Earlier in my career, I worked as an investment banking analyst on Wall Street at JPMorgan Chase & Co., and I have an M.B.A. from Harvard University and a B.S.E. in finance from the Wharton School of the University of Pennsylvania.