Individual Retirement Accounts
What is an IRA?
An IRA is a type of account for individuals to save money for retirement. (Age 59 1/2) Tax breaks are the main incentive for investing in IRA's. You can get a tax deduction upfront (Traditional IRA) or you can invest after-tax dollars and then get completely tax free withdrawals in retirement (Roth IRA) as long as you follow the rules. An IRA is not an investment, it is the type of account that holds the investment. There are many options to invest in inside of your IRA. You can own stocks, bonds, bank cd's, mutual funds, and ETF's inside of your IRA.
The IRS limits the amount you can contribute to these accounts each year. In 2020 you can contribute up to $6,000 ($7,000 for ages 50 or older). They also have other restrictions, for example, you must have earned income to contribute and if you make more than a certain amount then you become phased out of being able to deduct your contribution or in the case of the Roth you can't contribute at all.
Types of IRA Accounts
Traditional IRA
You get a tax deduction upfront when you contribute to a traditional IRA. Because of the upfront deduction, you will pay ordinary income taxes on the full amount of any withdrawals you make in retirement. It makes sense to contribute to a traditional IRA if you have taxable earned income, you are in a high tax bracket, you qualify for the deduction and you believe you will be in a lower tax bracket in retirement. You can open a traditional IRA at all the big banks or online brokerages like Fidelity, Vanguard, Schwab, Scottrade, Etrade, TD Ameritrade, or Betterment.
A big detail to remember is that this money is for retirement. You can not take a loan from your IRA. If you take a withdrawal before age 59 1/2 the IRS will hit you with a 10% penalty plus you have to pay ordinary income tax on the withdrawal. There are a few exceptions to paying the penalty like first-time homebuyer and college expenses, but you still have to pay the income tax.
Roth IRA
Roth IRAs are funded using after-tax dollars meaning you do not get a tax deduction when you make the contribution. Instead, you get the benefit of completely tax-free withdrawals in retirement. There are some rules that are specific to the Roth that need to be followed for the withdrawals to be tax-free. A Roth IRA can be a great option if you have taxable earned income, you are in a low tax bracket and you are under the income limitations. You can open a Roth IRA at all the same institutions as the traditional.
A big difference with a Roth is that you can withdraw your contributions at any time without taxes or penalties. This is a very nice feature. For example, if you have contributed $20,000 over the last 4 years and the account value has grown to $30,000 you would be able to withdraw your $20,000 of contributions without owing any taxes or penalties. I like the flexibility this offers because sometimes life gets in the way of our master plan. It is nice to be able to tap these funds if your circumstances change. The flip side is that it makes it easy to dip into retirement money which may not be the greatest idea. It is always good to talk to an expert that you trust to give you unbiased advice before making any big decisions.
Flow Charts
Rollover IRA
A rollover IRA is an account you set up to accept a transfer or "rollover" from an employer-sponsored retirement plan like a 401k or 403b. For example, if you switch jobs it might not be in your best interest to leave your 401k behind with your former employer. (But it might be in your best interests to leave it so be careful) You can instead rollover your old 401k into an IRA. Once you complete the rollover the funds are now subjected to the same rules as the type of IRA you rolled it into.
Inherited IRA
An inherited IRA is an account you set up when you have inherited an IRA or 401k resulting from the death of the original account owner. The rules around inherited IRAs can be complex and are different depending on the type of account you inherited and if you are a spouse or non-spouse beneficiary. Rather than getting into all the rules and options around this, here is a link to a very good breakdown on the Charles Schwab investor website.
