When it comes to planning for retirement—Americans are behind the curve. A recent survey conducted by an independent research firm for the TIAA-CREF found that over half of those surveyed do not understand what an IRA is. It should be no surprise then that around 80% report that they indeed do not make regular contributions to an IRA.
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What is an IRA?
IRA stands for “Individual Retirement Account”. While the IRA comes in a number of shapes and sizes, the common theme for all IRAs is that it allows individuals to put away savings for retirement in a tax deductible or tax free manner.
What are the different types of IRAs?
The two main types of IRAs that you here about normally are the traditional IRA and the Roth IRA. On first glance, these two types of investment savings may seem identical, but they actually have several key distinctions.
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- Eligibility: While traditional IRAs are open to everyone, regardless of income level, Roth IRAs are only available to single individuals making up to $95,000 or married couples making up to $150,000.
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- Taxation: Contributions made to traditional IRA accounts are tax deductible, unlike the Roth IRA. For the Roth IRA, if you make $30,000 a year and make a $2,000 contribution, you owe taxes on the full $30,000 and not $28,000 like you would in a traditional account. On the other hand, when you become of age and make withdrawals from your IRA of choice, the withdrawals from a Roth IRA won’t be taxed, unlike the traditional IRA.
- Withdrawal: You can make withdrawals at any time from a Roth IRA. These withdrawals are subject to particular minimum conditions. On the other hand, for the traditional IRA, if you make any withdrawals before the age of 59 ½, you must pay a 10% penalty fee and income taxes on your withdrawal.
Other less well known IRAs includes:
- Spousal IRA: an IRA for non-income earning spouses.
- Rollover IRA: an IRA that allows flexible rollovers in savings as you switch jobs.
- SEP-IRA: an IRA plan for the self-employed.
- SIMPLE-IRA: an IRA catered to small business owners.
- Education IRA: used to pay for college.
What are the advantages of an IRA?
The primary advantage of the IRA is in essence represented in the following term: compound interest. No matter the type of IRA account you choose, if you make regular contributions from an early age, you will be left with quite a nest egg by the time you reach retirement age.
For example, if at the age of 23 you started to contribute the maximum of $5,000 a year to an IRA, by the time you hit 63, assuming stable returns, you would be sitting on over $2 million. If you had a Roth IRA, you could start making withdrawals from that $2 million account tax-free.
After examining options at over 70 account providers in the U.S., NerdWallet found these to be the top Roth IRAs worth opening:
What are the limitations of an IRA?
There are yearly maximums that the federal government enforces, so forget about stashing away all of your yearly savings away from the purview of the taxman. If you are under the age of 50, you are limited to a maximum deposit of $5,000 a year. Furthermore, if you have to dip into your IRA before you hit the age of 50 ½, you will be forced to pay a penalty fee of 10%. This fee is waived if you are withdrawing money to pay for the following expenses:
- College expenses for dependents and spouses
- Disability expenses
- Medical expenses
- First-time home expenses
One other exception is if you have just recently put away your yearly contribution to your IRA and then soon after decide you want it back. You can get your money returned as long as it is before you have filed your taxes and subsequently abstain from listing the amount withdrawn and returned as a tax deductible amount in your returns.
Before writing IRAs off as another complicated retirement tool described in gibberish, consider writing off your taxes on a million dollar retirement savings plan instead. IRAs may seem complicated on first glance, but in fact are fairly basic and can yield extraordinary savings.
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