Thinking about retirement can be painful and scary because you're probably not sure if you'll have enough saved. But since you are here you are probably looking for an answer to: what is an IRA. And the good news is that the more you learn about personal finance, the more you'll realize it's not as complicated as it seems.
An IRA is a retirement savings and investment account with tax benefits.
We will tell you everything you need to know about IRAs in this article, including whether you should open a Roth IRA or a Traditional IRA, how to open an IRA account, and what the rules for the account are.
But knowing what an IRA is isn't enough, you need to take action by opening an IRA account and contributing to it regularly.
It's just like eating healthy. Knowing you need to eat healthily is the first step, but the most important part is actually doing it.
Sadly, the reality for most Americans is that they won't be able to retire without their children's financial support. UNLESS they make a change.
Most people have heard of a 401K but may not know what an IRA is. So, what is an IRA and what is a Roth IRA? That's exactly what we are explaining today.
We Should Have Opened A Roth IRA Sooner
Let's be honest here. When we first started our careers, we had absolutely NO idea what a Traditional IRA or a Roth IRA was. Not even the slightest clue. We vaguely knew it was a ‘retirement thing'.
Not having a Roth IRA sooner is one of the money mistakes we've made. And maybe you made the same mistake, but that's okay. It's not too late.
Francisco spent the majority of his 20's in school. I, however, started working in NYC when I was 22 years old. (You might remember some of the personal finance lessons I learned working on Wall Street.)
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 we spent the time to learn the ins and outs of IRAs, we both contribute to them regularly and have never looked back.
Today, we will teach you everything we wish we would have known years ago.
What Is An IRA?
An IRA (Individual Retirement Arrangement) is a retirement account 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.
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.
What Is A Traditional IRA?
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).
Anyone can open a Traditional IRA as long as you earned taxable 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 means that you will defer taxes now 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 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 IRA deduction is determined under the “single” filing status.
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.
What Is A Roth IRA?
Roth IRAs are similar to Traditional IRAs, but there are some important differences. The first is that Roth IRA contributions are made with AFTER-TAX dollars. You cannot deduct these contributions from your income during tax season.
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.
Should I Open A Traditional IRA Or A Roth IRA?
Which Type Of IRA Should You Get?
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?
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.
Short answer: Since we are still in our 20’s and our best earning years are ahead of us (like many of you!) we use Roth IRAs. We also like that the Roth IRA allows us to take our contributions out penalty-free without having to worry about exceptions.
How Do I Open A Traditional IRA Or A Roth IRA?
It's super easy! If you are ready to open an IRA, read our step-by-step guide on opening IRAs. Below is a nice summary.
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 2%, you will only get 6% (and that is assuming they earn as much as a diversified index fund, which may not even always be the case).
Where Do I Open An IRA Account?
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 Or Complicated To Manage An IRA?
No! 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! Data has shown that picking individual stocks is for dummies. If you don’t believe us, just google what Warren Buffet has to say about index funds. We will just save you the trouble though because he freaking loves them.
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.
We just want you to help yourself!
You can do it, we know you can.
Camilo is a personal finance expert who was raised in poverty by a single mother and had to learn everything about personal finance on his own. In addition to running The Finance Twins with his twin brother, he has been featured on Forbes, Business Insider, CNBC, US News, The Simple Dollar and other top publications. Camilo began his career as an investment banking analyst on Wall Street at J.P. Morgan. He has a master of business administration (M.B.A.) degree from Harvard University and a Bachelor of Science in finance from the Wharton School of Business at the University of Pennsylvania. You can contact Camilo here or via Instagram @thefinancetwins.