What You Need to Know About IRAs

What's a well-known investment vehicle that's attracted hard-earned money for more than four decades? Here's a hint: It's all about retirement.

Individual retirement accounts, or IRAs, account for a significant portion of Americans' retirement savings. Investors held approximately $9.2 trillion in IRAs at the end of March 2018, representing nearly one third of retirement assets, according to the Investment Company Institute.

If you're interested in opening an IRA account, here's what you need to know.

What Is an IRA?

Individual retirement accounts allow you to make tax-advantaged contributions to save for retirement. You can set up an IRA through a financial services company, such as a bank, brokerage firm or insurance company. As with employer-sponsored 401(k) plans, IRA account holders can choose how to invest their retirement funds—though typically with a wider range of investment options than you might see in a 401(k) plan.

The government initially created IRAs in 1974 to give more flexibility to savers and to allow workers without access to employer-sponsored pension plans an opportunity to save for retirement. But today, even those participating in employer-sponsored retirement plans are eligible to contribute to IRAs. IRA accounts come with specific tax advantages, depending on your income, whether you have access to an employer-sponsored plan and which type you choose.

What Are Your Options?

The two primary types of IRAs are the traditional IRA and the Roth IRA.

  • Traditional IRA: In a traditional IRA, you deduct your retirement contributions from your taxable income, subject to some income thresholds and other restrictions, such as whether you (or your spouse) are covered by a employer-sponsored retirement plan. Per the IRS, if you are married and your spouse is covered by a retirement plan at work and you aren't, and you live with your spouse or file a joint return, your deduction is phased out if your modified AGI is more than $186,000 but less than $196,000. If your modified AGI is $196,000 or more, you can't take a deduction for contributions to a traditional IRA.

    If you aren't eligible to deduct your contributions from your taxable income, a traditional IRA account could still be a good choice for you. The earnings on the investments in your IRA account grow tax-deferred. That means you'll only face taxes on earnings when you withdraw money from your IRA account in retirement.

    Owners of traditional IRA accounts may contribute to their accounts until age 70½. Those seeking an immediate tax break and/or those who expect to be in a lower tax bracket upon retirement than they are at present may find traditional IRAs to be a particularly good choice.
  • Roth IRA: Roth IRA contributions are not deductible from your taxable income. However, money in Roth IRA accounts grows tax-free. Unlike a traditional IRA, the earnings on your Roth contributions may be withdrawn tax-free as long as the account has been open at least five years and you are 59½ or older. You can withdraw the money you contribute at any time without taxes or penalties (the earnings on those contributions, however, may be subject to taxes or penalties if you wish to withdraw them early).

    There is no age limit on Roth IRA contributions (and no requirement to begin taking contributions by a certain age), but not everyone is eligible to participate in a Roth IRA.

    Those with incomes exceeding a certain threshold are not allowed to contribute to Roth IRAs. In 2018, if you're single or filing as the head of household, your modified adjusted gross income (MAGI) must be less than $135,000 to contribute to a Roth IRA, and contributions begin to phase out starting at $120,000. If you are married filing jointly or widowed, your MAGI must be less than $199,000 to make a Roth IRA contribution, and contributions begin to phase out at $189,000.

    Those who expect to be in a higher tax bracket upon retirement than they are at present may find Roth IRAs to be a good choice.

    Regardless of your tax bracket, you can convert a traditional IRA to a Roth IRA, but you must pay taxes on the amount you convert at ordinary federal and state rates. Once funds are converted to a Roth, all growth is tax-free. You can make tax-free withdrawals in accordance with IRS guidelines (more on that below).

Other options: There are also other IRA account choices. Spousal IRA accounts can be of the traditional or Roth variety and are reserved for nonworking spouses, allowing them to build their retirement savings despite not earning income (income limits may apply). Deemed or "sidecar" IRAs are IRA accounts through which employers automatically deduct an employee's IRA contributions from their after-tax compensation. They, too, follow the rules for traditional or Roth IRAs.

How Much Can You Contribute?

For 2018, anyone under the age of 50 can contribute up to $5,500 to his or her IRA accounts per year. Those 50 or older may contribute up to $6,500. However, your contributions can't exceed your taxable income, so if your taxable income is less than those limits, you can only contribute up to the value of your taxable income.

However, there is no limit on how much you can roll over from an existing fund to another fund.

When Can You Withdraw Money?

For a traditional IRA account, withdrawing funds before age 59½ may lead to a 10 percent tax penalty on the withdrawal, plus any taxes owed on any earnings withdrawn from the account.

For Roth IRA accounts, contributions may be withdrawn tax-free at any time. Any earnings on your contributions are still subject to the 10 percent penalty unless the account has been open at least five years and you are 59½ or older.

You may be able to avoid penalties if you meet certain IRS conditions, such as purchasing your first home. Rules regarding first-time home buying exceptions are complicated for both traditional and Roth IRAs and you would do well to consult with a tax professional before you take action.

Generally speaking, the longer you wait to withdraw your retirement savings the better. You not only avoid penalties (if you don't withdraw before 59½) but also allow your retirement savings to compound over time, increasing the amount of funds you have available in retirement.

Some may have the resources to delay their IRA account withdrawals beyond their retirement date, but whether you can actually do that depends on your type of IRA. Roth IRA account owners may delay their withdrawals as long as they'd like, but traditional IRA account holders are required to begin taking minimum distributions by age 70½. To determine the size of your required minimum distributions, use FINRA's required minimum distribution calculator.

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