Published November 8, 2018|6 min read
Whether you’re just starting to save for retirement or you want to supplement your existing plan, an individual retirement account is a great option. IRAs are easy to open and provide significant tax benefits that can help you retire when ready. But there are different types of IRAs, with strict rules governing how they can be used and you also have multiple options for managing your investments. Here’s an explainer on IRAs and tips on how to open one.
An IRA is a savings vehicle that allows you to save and invest funds tax-free or tax-deferred for retirement. The funds you contribute to an IRA can be invested in stocks, CDs, mutual funds, bonds and more. Over time, these investments can grow into a sizeable nest egg. Just about anyone can open an IRA, though there are income limits for certain types. Investments in an IRA can be managed by yourself, a financial adviser or, in this day and age, an investment app.
There are distinct tax benefits to participating in an IRA. You can make after-tax contributions to an IRA, with any investment earnings growing tax-free or you can defer paying taxes on contributions and earnings until you withdraw funds in retirement.
IRAs are especially useful for people who don’t have access to an employer-sponsored retirement plan. (Learn how to build your own benefits package.) But even if you already participate in a 401(k), IRAs can help you save more, especially if you’re maxing out your 401(k) contributions.
For tax year 2018, you can contribute up to $5,500 to an IRA. Beginning in 2019, you can contribute up to $6,000. If you’re 50 or older, you can make an extra $1,000 per year in “catch-up” contributions.
Plus, “you do have more flexibility with an IRA than a 401(k),” Philip H. Weiss, certified public accountant and principal at Apprise Wealth Management, says. “The investment options in a 401(k) plan are limited to what the plan allows. If you have an IRA you can invest in individual stocks, , mutual funds, as well as some other less commonly traded securities.”
IRAs come in many types, with specialized options for sole proprietors, small business owners and even spouses who wish to contribute to their partner’s retirement. For our purposes, we’ll focus on the most common types: traditional IRAs and Roth IRAs. The biggest differences between these two options involve how tax breaks and penalties apply.
Contributions to a traditional IRA are tax-deductible and earnings are tax-deferred. You square up with Uncle Sam when you withdraw money — and, in most cases, you’ll pay a penalty if you tap the funds before you turn 59-and-a-half. You’ll also pay a penalty if you don’t start taking minimum distributions from the account once you turn 70-and-a-half.
There are no income limits to contribute to a traditional IRA, but there are limits on tax deductions based on your modified adjusted gross income (MAGI) and filing status if you participate in a workplace retirement plan.
2019 traditional IRA deduction limits
If you’re contributing to an IRA and not covered by a workplace retirement plan, but married to someone who is, the deduction phases out if you collectively make between $193,000 and $203,000.
Contributions to a Roth IRA are subject to taxation, but your earnings grow tax-free, and you generally don’t pay taxes on withdrawals. There is no age requirement for taking minimum distributions. However, there are income limits on contributions to a Roth IRA.
2019 Roth IRA Contribution Limits
An IRA can be opened in a few easy steps, and the process can move quickly once you find the right provider. Here's a primer on how to tackle that last part.
First, you will need to choose whether you want to open a traditional IRA or Roth IRA. Keeping the aforementioned deduction and contribution limits in mind, here are other major factors to mull:
Traditional IRA: Traditional IRAs let you avoid taxes on contributions, so they’re a good choice if you anticipate being in a lower tax bracket when you’re making withdrawals (aka in retirement). They’re also a good option for workers who don’t have an employer-sponsored retirement plan.
Roth IRA: Roth IRAs require you to pay taxes on your contributions up front, but avoid all taxes on your earnings. They’re a good fit for anyone who believes they will be in a higher tax bracket in retirement. As such, they’re usually a good bet for anyone just starting out in their career.
You can also open and contribute to both types of accounts. Technically, you can have as many IRAs as you wish. However, the $5,500 contribution limit applies across all of your IRAs.
You can open an IRA through traditional or online banks, brokerage firms or mutual fund companies. Choosing which financial institution to tap is largely influenced by how you prefer to invest and manage the money you put into the account. Here are your major options.
You can do it yourself, in which case you’re best-served opening the account with an online broker, like E-trade, that lets you buy or sell investments. You won’t pay an account management fee; you will generally pay commissions or fees on your trades.
You can hire a robo-adviser. Investment apps use mathematical rules and algorithms to automatically manage and rebalance your portfolio for relatively low management fees and commissions. Many of them, including Pg partner Betterment, allow you to message financial planners in-app or pay a higher fee for broader personal service.
You can tap a (human) financial planner. Certified financial planners generally charge higher management or commission fees in exchange for one-on-one time and broad availability. Here’s how to find a reputable financial adviser in your area.
Deciding how hands on you want to be when it comes to managing your IRA will help you …
Whether you prefer hands-on or hands-off account management, compare the following fine print across providers:
Account fees: Common charges include account management or maintenance fees, transfer fees, trading commissions or advisory fees. They’re usually presented as a percentage of your investments. Consider these fees in totality, stacked against the suite of services the provider is promising.
Account minimums: Some IRAs require a minimum deposit to open your account, or have fees that increases when you exceed certain balance thresholds.
Suite of investments: You can invest in stocks, CDs, mutual funds, bonds, exchange-traded funds and more. Make sure the account you open offers the particular investment or mix of investments you’re interested in.
You should make sure your broker is well-known, reputable and regulated by the Securities and Exchange Commission or Internal Revenue Service, says Ryan Firth, certified public accountant and president at Mercer Street, a financial and tax services firm.
You can vet brokers or financial advisers using BrokerCheck, a free, online tool from the Financial Industry Regulatory Authority (FINRA).
Once you choose your financial institution and plan, opening an IRA is pretty simple. You can usually complete the task online through the company’s app or website. You’ll need personal information including your name, address, birthdate and Social Security number. Depending on the plan, you may need an initial deposit to get started.
After that, it’s time to fund your account. At this point, it’s time to choose your investments. You can choose them yourself or heed the recommendations of your adviser.
Each year, you have a 15-month window to contribute the annual maximum to your IRA. You can contribute to the annual limit from January 1 to the tax filing deadline in April the following year.
Generally, it’s a good idea to contribute the maximum allowable amount ($5,500 for tax year 2018; $6,000, beginning tax year 2019). You can contribute to your IRA all at once, or throughout the 15-month window. There are several ways to fund your account:
Rollover: You can roll over assets from an employer-sponsored plan, such as a 401(k), into an IRA. These rollovers won’t suffer any penalties or lose benefits. You can rollover multiple retirement accounts into an IRA, up to the annual limit. Usually, rollovers require a qualifying event, such as leaving your employer or reaching age 59-and-a-half.
Direct contribution: You can cut a check or make an electronic transfer from your bank account.
Payroll deductions: Though they aren’t required to do so, some employers allow you to automatically contribute to your IRA from your paycheck.
Once you are 59-and-a-half, you can withdraw from your IRA penalty-free. As mentioned above, you must begin taking an annual minimum distribution from a traditional IRA at age 70-and-a-half or face a steep 50% penalty. Withdrawals from a traditional IRA are taxed at the current rate.
There are no such age requirements for Roth IRAs. Roth IRA withdrawals in retirement are tax-free.
Avoid early withdrawals, no matter what IRA you’ve opened. For Roth IRAs, contribution withdrawals are tax and penalty-free, but withdrawal of your earnings (any funds that total more than your contributions) are taxed at your current rate and subject to a 10% penalty. There are a few exceptions, including:
If you’ve had your Roth IRA for at least five years and you’re buying your first home, you can withdraw up to $10,000.
If you’ve had your Roth IRA for at least five years and you die or suffer a severe disability, the funds are fully accessible or paid out to your estate (which would only happen if you didn't have a designated beneficiary named on the account).
For traditional IRAs, your early withdrawals are subject to taxation and you will pay a 10% early withdrawal tax penalty. There are a few exceptions:
If you’re buying your first home, you can withdraw up to $10,000 ($20,000 for married couples).
You have qualified education expenses, though it can reduce your eligibility for financial aid.
In the event of death or disability.
If you have unreimbursed medical expenses that exceed 10% of your adjusted gross income, you can withdraw money to pay those bills.
If you’re on unemployment for 12 consecutive weeks, you can withdraw money to pay for health insurance.
“There are various strategies one can utilize to avoid the 10% excise tax for early withdrawals,” Firth said. “However, I would recommend consulting with a qualified tax professional before pursuing any such strategy on one's own.”
Choosing between a traditional IRA and a Roth IRA can be difficult because it’s hard to predict the tax bracket you’ll be in once you retire. Betterment has a good guide to the pros and cons of each IRA type.
Do you think you can’t afford to save for retirement? Here’s some advice on how to start your nest egg.
Not sure how much you should be saving for retirement? Charles Schwab has some general guidelines.
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