What is an IRA ? Why One should Open an IRA account?

13 Jul 2020

A secure and happy retirement is what we aim for. We need to plan for a healthy retired life. For this, we need the IRA that stands for Individual Retirement Account. It is a significant saving vehicle for those who are planning to have a monetarily safe retirement. This account helps the individual earmark the money and use after retirement. In this article, you will get an insight into what the IRA account is, individual retirement account pros and cons and facts associated with this.

What is the definition of an Individual Retirement Account?

IRA stands for Individual Retirement Account. As the name indicates, it’s the account which an individual can use to save money for the future. An important point to note about IRA is that it is tax-deferred account thus giving you tax benefits as well. Undoubtedly, it is one of the most powerful ways to save money for the future.

Opposite to the perception about the IRA, it is an investment account that a person sets up at a brokerage firm or other financial institution. You keep on adding money to this account and use it to purchase stocks, mutual funds, etc. The account holder can eventually withdraw the money in the account to receive income after retirement.

What are the types of IRA Account?

There are two major types of IRA:

  • Traditional IRA- Here you get the tax benefit on your current tax rate. If you assume that the current tax rate paid by you is on a higher side than what you will have after retirement, then you can opt for the traditional IRA.

  • Roth IRA- Here, the contributions are made with post-tax dollars. It means that the tax is not deducted from the taxable income.

And few people also go for a Simplified Employee Pension (IRA). Later in this blog, we will discuss this.

Read Here:  Traditional IRA vs Roth IRA

What are the eligibility criteria for opening Individual Retirement Accounts USA?

The eligibility of either of these IRA accounts is based on income. In the case of Roth IRA, individuals whose income is below a certain threshold are allowed to fund an account. While anyone can contribute to a traditional IRA, an important point to note about the traditional IRA is that you are allowed to deduct the amount limited by your income.

What are the tax rules for IRA accounts?

As mentioned above, the tax rules for these IRAs are different. These are further sub-categorized as follows:

1.    Traditional IRA is sub-categorized as non-deductible (taxable) IRAs, Simple IRAs, spousal IRA contributions and SEP IRAs.

2.    Roth IRA- We categorizes this as Roth spousal IRA contributions and Roth 401(k) which is known as Designated Roth account.

The eligibility of either of these IRA accounts is based on income. In the case of Roth IRA, individuals whose income is below a certain threshold are allowed to fund an account. While anyone can contribute to a traditional IRA, an important point to note about a traditional IRA is that you are allowed to deducting the amount limited by your income.

Simplified Employee Pension IRAs

If you are a self-employed individual and are looking for an investment for retirement, then SEP IRA or the Simplified Employee Pension IRA is a good move. This plan is suitable for self-employed individuals.

Who are eligible for this scheme?

All self-employed individuals like contractors, freelancers, small business owners, etc. The taxation rules for the SEP IRA is similar to that of the traditional IRA.

An important point to note about SEP IRA is that the business owners who set up this scheme for their employees can deduct the contributions from their business income and thus can save on tax.

What are the things that separate Traditional and Roth IRAs?

Both these accounts bear a significant difference in certain important parameters such as age, income, and taxation. We will discuss various aspects where they differ so that you are able to make a well-informed decision.

  1. Age and Income

If you are below the age of 70 ½ and have a steady income, you can very well contribute to a traditional IRA. On the contrary, Roth IRAs do not impose restrictions on age, but they come up with income eligibility criteria. As per the latest eligibility norms for the year 2019, a single taxpayer with a MAGI or modified adjusted gross income of less than $137,000 can also contribute to a Roth IRA. A couple having a MAGI of below $203,000 and filing tax jointly can also make contributions to a Roth IRA.

  1. Tax benefits

Both these IRAs offer significant tax benefits, but with a difference in relation to the time of availing these benefits. While the Roth IRAs allow you to have the tax exemption benefits at withdrawal, their traditional counterparts are tax-deductible at the time the contributions are made. In the case of the Traditional IRAs, the withdrawal will be taxed at the normal rates apply. Both these IRAs provide a major boost to tax-saving. You just need to decide when you actually want to avail such tax rebates and choose your IRA accordingly.

Both the Traditional IRA and Roth IRA differ in the way they make provisions for the tax-deductible contributions. In Roth IRA accounts, contributions are made with the ‘post-tax’ money and hence, they are exempted from tax. However, traditional IRAs allow you to make tax-deductible contributions.

The tax benefits, as usual, depending on your tax bracket and your income level. With the Traditional IRA, your money grows ‘tax-free’ till the same is withdrawn but, with the Roth IRA, only employees belonging to a few specified income levels can have this ‘tax-free’ growth.

When it comes to the Roth IRA, the amount accumulated ‘post-tax’ is equal to the total account value. But, when it comes to the Traditional IRA, it is the sum of two amounts- first, your account value after income tax is paid on your total earnings and the tax-deductible contributions and second, the earnings from the tax savings you have ‘re-invested’.

  1. Withdrawal rules of the IRAs

When it comes to the Traditional IRA, you need to start the Required Minimum Distribution (RMD) immediately upon reaching the age of 70½, regardless of whether you require the fund at that time or not. These withdrawals are taxable and the taxed amount depends upon your total fund value. However, when it comes to Roth IRAs, you have the flexibility to accept the withdrawal at your preferred time. You can decide to let the fund grow throughout your entire life or you may even pass it to your heirs as well. Your heirs may also decide to stretch out the distribution till the time they actually need funds.

But, do have in mind that an aging requirement of 5 years is required to be met to avail a tax-free and penalty-free distribution in case of Roth IRAs after you are aged 59½ and beyond. Whereas, with the traditional IRAs, you are not required to meet any aging requirements even if you are below the age of 59½. Also, traditional IRAs allow you to withdraw an amount up to $10,000 to meet the first-time home-buyer expenses and you do not need to pay the usual penalty for early withdrawal.

Another point to consider in favor of traditional IRAs is that it provides you with tax incentives in the year of the contribution itself. This reduces the adjusted gross income for you and gives you opportunities for other tax incentives.

Here is the tabular comparison of all the three types of IRA:

Type of IRA

Contribution Limit

Tax- Deductible Contributions

Tax-Free Distribution

Who can Establish

Traditional IRA

$5,500 if the age is less than 50 and if the age is 50 years or above then contribution limit is  $6,500 (2018)

Individual deduction amounts are subject to income.

No

Individual taxpayers and couples

Roth

$5,500 if the age is less than 50 and if the age is 50 years or above then contribution limit is  $6,500 (2018)

No

Yes

This scheme applies to individual taxpayers and couples (Subject to MAGI limitations).

SEP

$55,000 or It is lesser of 25% of compensation

For employees; the business deductions are limited to lesser of 25% of the compensation.

No

The scheme is the best for small business owners and self-employed personnel.

Why should one open IRA account?

Well, planning for the future is the best step that you can take at this time. This becomes even more important if you are planning for your retirement. It helps in securing the future and ensuring that you don’t have to stand still when it comes to meeting the financial needs. Apart from this, there are various other benefits offered by the IRA account:

  • Tax benefit- Saving on tax is one of the significant benefits of the IRA account. The tax-deductible is up to the IRS limits.

  • Tax-deferred – Both the Roth IRA and traditional IRA are tax-deferred.

  • It allows the person to contribute up to $5,500 every year.

  • Individuals above the age of 50 can save more. They can save around $1000 extra every year.

  • By investing in the IRA, you get the advantage of spending in a wide array of investment products was compared to the plans offered by your employer.

An important point to note about IRA is that one should not withdraw the money from the account before retirement. IRA allows the individual to take out money before the age of 59 ½ to meet certain expenses.

How to open an IRA?

If you have decided to open the IRA and are wondering whom to contact, then you need to keep the following points into consideration:

Go online- The first way is you can yourself manage and open IRA online. Here you will manage your investment. Various portals will guide you for the same.

Robo-advisor- You can move to the second step if you don’t wish to manage things yourself. Robo-advisor is the move that you must make. It will choose a low-cost fund and rebalance your portfolio taking care of your investing preferences.  

Important Points about IRA:

When talking about annual contribution limit for an IRA, if the person is under the age of 50, then he can contribute up to $5,500 (2018) and $6000 (2019 the age is 50 or above).

In a tax year, an individual can additionally contribute $1000 catch-up contribution for a total of up to $5,500 in 2018 and $7,000 in 2019.

Many a time people wonder if they can contribute to both traditional IRA and Roth IRA. Then you must know that you can do it, the condition being that you can meet the eligibility parameters.  Another critical point to note is that the combined total contribution does not exceed the contribution limit or 100% of the incomes. For example, for the year 2019, one cannot contribute to both Traditional IRA and Roth IRA an amount which is not more than $6000 and if the age of the contributor is 50 or above the amount cannot be more than $7000.

One of the confusions that arise while choosing a retirement plan is whether IRA is the same as 401(k). It is worth noting that both these are different types of a retirement account. Whereas an individual opens an IRA, the 401(k) is employer-sponsored retirement scheme. Although both, IRA and 401(k) have tax benefits but 401(k) has higher contribution limits which are around $19,000 per year.

Penalty on withdrawals:

There is a penalty fee if you withdraw before the set period. But, there are conditions like you can use some of the amounts in your IRA account to set medical bills, higher education expenses, and health insurance premiums. So, before you plan to withdraw money for any of the mentioned reasons, it would always be good to take into consideration the penalty levied on it.

Conclusion- Who doesn't want secure retirement; IRA empowers you to make your retirement happy and prosperous so that you don’t fall short of finances to meet your needs. If you are planning for a comfortable and are looking for a plan that can give you excellent benefits post-retirement, then opening an IRA account is the right step for you.