WTF is an IRA?
Breaking down Individual Retirement Accounts
One key strategy in building a robust financial portfolio is understanding and utilizing Individual Retirement Accounts, or IRAs.
Today, we're diving deep into the world of IRAs. We'll explore what they are, how they differ from other retirement accounts like 401(k)s, and the various rules and restrictions that come with them.
We'll also discuss the different types of IRAs, how to choose the right one, what a backdoor Roth IRA is, and how to set up your first IRA.
What is an IRA, and what does it stand for?
An IRA, officially known by the IRS as an Individual Retirement Arrangement, is a long-term investment account designed to help you save for retirement.
While its formal name might sound complex, it is more commonly called an Individual Retirement Account because it clearly describes its purpose. Like a 401(k), an IRA is a tax-advantaged account, meaning you receive tax benefits for investing in and holding your money within this type of account. These tax advantages can significantly enhance your retirement savings, making IRAs a crucial component of a well-rounded financial plan.
What is the difference between an IRA and 401(k)?
One of the most significant differences between an IRA and a 401(k) is accessibility. Any American can open an IRA, which is not tied to an employer. However, you need some earned income to contribute to an IRA. This flexibility is a significant advantage because you can choose the brokerage firm for your IRA, unlike a 401(k), where the employer dictates the plan and the financial institution that administers it. This freedom allows you to shop for the best services and fees, tailoring your retirement account to your specific needs and preferences.
Another notable difference is the range of investment options. With an IRA, you have a broader selection of investment choices, particularly index funds, compared to a 401(k), where the investment options are limited by the plan administrator chosen by your employer. This wider range of options can provide greater opportunities for diversifying and optimizing your investment portfolio. However, it's important to note that 401(k) plans often come with the advantage of a company match, which is free money added to your retirement savings by your employer. This is a benefit that IRAs do not offer since they are individual accounts.
What about the rules and restrictions around IRAs?
Because the IRS provides tax breaks for investing in IRAs, there are certain restrictions on how much you can contribute each year and the age at which you can withdraw funds without penalty. IRA contribution limits are significantly lower than those for 401(k)s. For example, in 2023, the IRA contribution limit is $6,500, while for a 401(k), it is $22,500. This substantial difference highlights a key limitation of IRAs compared to employer-sponsored plans like 401(k)s.
Additionally, catch-up provisions for individuals aged 50 and older allow for higher contributions. In 2023, those over 50 can contribute up to $7,500 to an IRA, compared to $30,000 to a 401(k). These lower contribution limits for IRAs can be a drawback for those looking to maximize their retirement savings quickly. Despite these limitations, IRAs remain a valuable tool for retirement planning due to their flexibility and tax advantages.
Can you open up multiple IRAs and contribute the annual max to each?
This is a common question in our community, where many want to maximize their dollars and take advantage of tax breaks. You can indeed open multiple IRAs and hold them in your portfolio. Still, you can only contribute up to the annual maximum across all combined. For example, if you have three IRAs, you can still only contribute a total of $6,500 across all three accounts for the year. This contribution limit is cumulative, so having multiple IRAs does not allow you to exceed the annual maximum contribution limit.
Many people manage multiple IRAs in their portfolios for different strategic reasons. In contrast, others may prefer to stick with just one. There's no one-size-fits-all answer; it depends on your individual financial goals and circumstances. For instance, I have two IRAs, a Roth and a traditional, and we'll discuss the scenarios in which contributing to one type might be more advantageous than the other. Ultimately, your choice and number of IRAs should align with your overall retirement strategy and personal preferences.
What about the rules around taking your money out of your IRA?
The government has set rules for IRAs, designating them as long-term retirement investment accounts, which means you cannot withdraw from your IRA without penalty until you reach the age of 59 and a half. This age can be considered the government's designated retirement age for these accounts. If you withdraw funds before this age, you will incur income tax on the withdrawn amount and face a 10% penalty, making early withdrawals quite unfavorable. However, exceptions to this rule allow for penalty-free early withdrawals under certain circumstances, such as immediate and heavy financial needs, healthcare expenses, or buying a first-time home.
While these exceptions exist, early withdrawal from an IRA should be approached with caution. Withdrawing funds early depletes your retirement savings, reducing the time available for your investments to grow and compound. This can significantly impact your long-term financial health. It's crucial to thoroughly understand the implications and only consider early withdrawal if you are truly in dire straits. Although these exceptions provide a safety net, using them means potentially putting yourself in a less secure financial position for retirement. Always do your due diligence and consider the long-term consequences before deciding to pull from your IRA early.
What if you reach age 59.5 and don't need the money or want to wait to withdraw it?
You are not required to start withdrawing from your IRA at age 59 and a half. If you don't need the money, you can let it remain in your account to continue compounding and earning returns. However, you can't keep your money in an IRA indefinitely, as the IRS will eventually want to collect taxes on those funds. Starting at age 73, the IRS mandates that you begin taking required minimum distributions (RMDs) from your retirement accounts. Each year, the IRS publishes a table indicating the percentage you must withdraw based on your age. As you get older, the required percentage decreases due to a lower life expectancy.
The age at which RMDs begin is subject to change; it was 72 last year and is now 73. To stay updated, you should look up the IRS RMD tables regularly. Interestingly, while the RMD age has changed, the age for penalty-free withdrawals (59 and a half) has remained consistent and applies to both IRAs and 401(k)s. Many people coordinate their RMDs with Social Security payouts to optimize their retirement income and expenses. However, the focus remains on building wealth until retirement.
What are the different types of IRAs?
There are four main types of IRAs: Traditional IRA, Roth IRA, SIMPLE IRA, and SEP IRA. The Traditional and Roth IRAs are the most popular and have similar contribution limits and withdrawal rules. Still, they differ significantly in their tax treatment. With a Traditional IRA, you don't pay taxes on your contributions in the year they are made; instead, you defer the taxes until you withdraw the money. For example, suppose you contribute $6,500 to a Traditional IRA in 2023. In that case, you won't pay income taxes on that amount until you withdraw it after age 59 and a half. Conversely, with a Roth IRA, you pay taxes on your contributions upfront. Once the money is in the Roth IRA, it grows tax-free, and you won't pay taxes upon withdrawal.
SIMPLE and SEP IRAs are designed for self-employed individuals, such as freelancers and business owners, and have different contribution limits and rules. SIMPLE IRAs allow higher contributions than Traditional and Roth IRAs, with limits of $15,500 or $19,000 for those over 50 in 2023. SEP IRAs have even higher limits, allowing contributions of up to 25% of your salary or $66,000, whichever is less. The SEP IRA is typically better for business owners with few or no employees, as only the business owner can make contributions. In contrast, both employees and employers can contribute to SIMPLE IRAs, making them suitable for businesses with up to 100 employees. These options provide significant advantages for self-employed individuals who don't have access to employer-sponsored retirement plans, allowing them to maximize their retirement savings.
How do you determine which IRA is right for you?
Determining which IRA is right for you primarily comes down to tax considerations. Suppose you're self-employed or a small business owner. In that case, it's essential to consult with a CPA to decide whether a SEP or SIMPLE IRA would provide the most tax benefits, depending on how your business is structured and how you receive your income. For those not self-employed, choosing between a Traditional IRA and a Roth IRA hinges on whether you prefer to pay taxes now or later. This decision can be complex, but it's important to remember that both options offer significant benefits and should be chosen based on your financial situation.
For example, having both a Roth and a Traditional IRA can provide flexibility in managing annual tax liabilities, as I do. Contributing to one or the other based on my income and tax situation each year allows for optimal tax management. However, eligibility to contribute to a Roth IRA is subject to income limits. In 2023, single filers earning more than $150,000 and married couples filing jointly earning more than $228,000 cannot contribute to a Roth IRA. Those above these thresholds must use a Traditional IRA or consider a backdoor Roth conversion. Understanding these nuances can be overwhelming, but they are crucial for optimizing your retirement savings strategy. In our Wealth Circle, we take a holistic approach to help you navigate these decisions and choose the best accounts for your situation.
What is a backdoor Roth?
A backdoor Roth IRA is a strategy used by individuals who exceed the income threshold for directly contributing to a Roth IRA but still want to benefit from its tax-free advantages. Here's how it works: if you're over the income limit, you first contribute to a Traditional IRA but don't invest that money; instead, keep it in cash. Then, promptly transfer this money from your Traditional IRA to your Roth IRA. During tax filing, you pay income tax on the transferred amount, ensuring that all taxes are appropriately paid. This strategy is legal and essentially functions as a mini Roth conversion, offering tax benefits while adhering to tax regulations.
However, the success of a backdoor Roth IRA hinges on certain factors. Suppose the funds in your Traditional IRA have earned returns over the years. In that case, you'll incur additional taxes on these gains when converting to a Roth. Thus, a backdoor Roth may not be the optimal strategy if your Traditional IRA has significant earnings due to the potential tax implications. Researching this strategy thoroughly and consulting with a CPA or tax professional is crucial to avoid unexpected tax liabilities and ensure a smooth execution.
If someone already has a 401(k), would it also be beneficial to have an IRA?
Having an IRA in your portfolio, especially if you don't have an employer-sponsored account like a 401(k), is crucial for retirement planning. However, even if you have a 401(k), having an IRA alongside it can provide additional retirement and tax benefits. Many in the Factorial Community prioritize contributing to their 401(k) to maximize employer matches and then max out their IRA for the investment freedom it offers. This strategy allows for a well-rounded approach to retirement savings and tax planning. While it's not necessary to contribute to both accounts every year, having them available ensures flexibility and readiness for optimal contributions when beneficial.
It's essential to diversify beyond tax-advantaged retirement accounts, though. These accounts are primarily for retirement savings; accessing funds before age 59 and a half can incur penalties. Hence, maintaining a taxable brokerage account alongside retirement accounts provides liquidity and flexibility for other financial goals and life events. The Wealth Circle and Factorial Community exist to guide individuals through these complexities, breaking down financial concepts step by step, just like assembling Lego pieces to create a comprehensive financial picture. Understanding and managing these accounts can be empowering and enjoyable, leading to a sense of financial confidence and control across all aspects of life.
What are the action steps to open an IR?
Decide on the type of IRA: Research and understand the tax implications and suitability of different types of IRAs using online resources like NerdWallet and Investopedia.
Choose a brokerage firm: Select a financial institution where you want to open your IRA account.
Complete necessary paperwork: Fill out the required forms to open your IRA with the chosen brokerage firm.
Fund your IRA: Contribute money to your IRA account, ensuring it is initially in cash.
Select your investments: Choose index funds or other underlying investments to ensure your money is invested in the stock market for potential compounding returns.
Set up automatic contributions: Consider setting up automatic contributions to fund your IRA consistently, easing the cognitive load and ensuring regular contributions.
Manage your IRA: Periodically review and adjust your investment choices as needed, especially as you approach retirement or experience different life stages.