How Does an IRA Work?
When you set aside funds for retirement, those funds need somewhere to hang out where they can collect interest and work to earn you more money, but also somewhere you won't touch them in a moment of impulse. As you contribute funds to your IRA, those funds can be invested in a variety of different assets such as stocks, bonds, or mutual funds allowing them to grow over time.
There are IRA contribution limits set by the Internal Revenue Service (IRS), required minimum distributions (RMDs) once you reach 73 years of age, and penalties for early withdrawal, but overall, an IRA account is a structured financial product designed to encourage disciplined saving while maximizing the growth potential of your investments.
Types of IRAs
Traditional IRA
A traditional IRA is perhaps the most common retirement savings option and one that allows you to contribute pre-tax income, meaning that you can lower your taxable income for the year (though there are no income limits for traditional IRAs, a lower gross income means a lesser tax burden). Your annual traditional IRA contributions are capped at $7,000 for 2024, though you can make an extra IRA contribution of $1,000 if you're 50 or older. Funds that you contribute grow tax-deferred until you withdraw them which is typically during retirement once you've slid into a lower tax bracket. But, if you dig in too early (before you turn 59½ years old), you'll have to pay a 10% early withdrawal penalty in addition to regular income tax on the amount you take out.
Roth IRA
Roth IRA contributions are made using after-tax dollars, meaning that you pay income tax first and then contribute to your retirement savings account. In 2024, you can contribute a maximum of $7,000 if you're under 50 years of age and an additional $1,000 catch-up contribution if you're 50 or over. There are specific income thresholds for Roth IRA contributions that are based on your modified adjusted gross income (MAGI) as well as your tax filing status, so you may not be able to contribute the full amount if you have a higher income.
The big advantage to a Roth IRA is that the funds you contribute grow tax-free (because they've already been taxed), and qualified withdrawals made after the age of 59½ are also tax-free as long as your account has been open for at least 5 years. Plus, contributions can be withdrawn penalty-free at any time (not earnings, just the contributions themselves). For these reasons, a Roth IRA is an excellent choice if you suspect that you'll remain in a higher tax bracket when you retire.
SEP IRA
A Simplified Employee Pension Individual Retirement Account (SEP IRA) is a retirement plan designed specifically for self-employed individuals or those who own businesses and allows them to make significant contributions to their retirement fund. Unlike other types of IRAs, only employers can contribute to SEP IRAs which makes them highly attractive for business owners who want to provide retirement benefits without wading into the complex waters of more traditional plans. Withdrawals from SEP IRAs are taxed as ordinary income and a 10% penalty applies if withdrawals are made before you turn 59½, but it remains a flexible and practical choice for those with fluctuating business revenues.
SIMPLE IRA
A Savings Incentive Match Plan for Employees Individual Retirement Account (SIMPLE IRA) is a long way of describing another retirement account designed for small businesses and those who are self-employed. Contributions to SIMPLE IRAs are made with pre-tax funds which can reduce your taxable income for that tax year and the funds grow tax-deferred until you withdraw them. Just like a SEP IRA, you'll face a 10% penalty for withdrawing before you reach 59½ years old.
How to Open an IRA
To open an IRA you'll need to choose either a financial institution, a brokerage firm, or a financial services provider such as PensionBee. Banks usually offer more conservative investment options whereas brokerages often have a broader array of assets to invest in which provides more flexibility. After you choose a provider, you'll need to gather and disclose your personal identification and financial information (Social Security number, date of birth, banking details, etc.) to begin funding the account. Once you're all set up, you can contribute funds via direct bank transfers, by check, or through automatic deposits.
Investment Options within an IRA
Your investment options within your IRA can be quite diverse, enabling you to tailor your portfolio to meet specific retirement goals. The most common choices include stocks and bonds which can provide solid growth potential and income generation, while mutual funds and exchange-traded funds (ETFs) offer a convenient way to invest in a basket of securities that are instantly diversified and professionally managed. If you're looking for something more exciting, many IRAs allow investments in real estate as well as commodities and cryptocurrencies. Whatever you decide to do, diversification is the name of the game, and scooping up a handful of different investments can contribute to a more robust retirement portfolio.
Tax Benefits of IRAs
The significant tax benefits of IRAs are among the most compelling reasons to choose them for your retirement planning, particularly in terms of contributions and growth. In the case of traditional IRAs, contributions can be tax-deductible and allow you to lower your taxable income by contributing pre-tax dollars. As for tax-deferred growth, both traditional and Roth IRAs can grow without being subject to annual taxes on your earnings which means they can compound over time and maximize your potential retirement funds.
Common Mistakes to Avoid
Early Withdrawals
Taking money out early is one of the biggest mistakes you can make with an IRA. If you do so before you turn 59½, you'll pay a painful 10% penalty in addition to the amount being taxed as ordinary income when you submit your tax return. There are some exceptions for early withdrawals such as medical expenses, but the best advice is to leave the funds alone if possible.
Over-Contributions
Going over your contributions is also ill-advised. The IRS sets limitations for a reason, you'll face a 6% excess contribution penalty if you go over, which will repeat each year until you fix the problem.
Ignoring Beneficiary Designations
If you fail to keep your beneficiary designations updated it can have negative implications for your IRA. When setting up your IRA you'll have the option to name a beneficiary in the event of your death, but life is messy and things change—if you don't keep the information updated to accurately reflect your wishes, your assets may not be distributed according to plan.
