Your smart and simple guide to IRAs

Aman Saxena
11.19.20
8 minute read

There are different avenues to save for retirement, but let’s breakdown one of the most popular ways for individuals- the IRA.

If you want to know what an IRA is, what it means and the different types that exist, you’ve come to the right place.

But remember, tax and investment advice is best taken from a professional that can understand your specific situation and goals.

📝 Table of contents

What are IRAs?

Individual Retirement Accounts, or IRA for short, were set up to help individuals, people and families plan for financial security in retirement. IRAs are investment vehicles that can be tax deductible at the time of contribution or withdrawal.

💵 You can contribute up to a certain amount to an IRA for you or your spouse every year while you are still working and earning income.

🏖 Then when you retire, you can draw down from the savings you have accumulated in the IRA.

The best place to start on the road to an IRA is to understand your current finances and where you want to go. You can choose to meet with a financial advisor or take a look yourself at where you currently stand in terms of cash flow, savings and investments.

Then, take a look at when you want to retire, and how much you may need as income then. There are some great tools available on the American Savings Education Council to help you get started on these calculations.

Be sure to also factor in Social Security benefits that also may kick in when you retire.

Once you have a good hold on where you are currently, and your retirement goals, you can start to assess which IRA would be best for you.

But not all IRAs are the same, and different IRAs behave differently. Let’s take a look.

🎯 Quick Take: IRAs
  • IRS approved retirement savings accounts
  • There are 4 types of IRAs
  • Contributions to certain IRAs can be tax deductible
  • A 10% penalty for withdrawing money before age 70 ½

The Different Types of IRAs

There are 4 main types of Individual Retirement Accounts.

  • Traditional IRA
  • Roth IRA
  • Rollover IRA
  • SEP

The first two are for individuals wanting to save for retirement, while the bottom two are for employers or businesses to set up retirement accounts for employees.

A Traditional IRA let’s you contribute to a retirement account and have the contributions be fully or partially deductible from your annual taxes now. But, you do have to pay taxes when you withdraw the funds in retirement.

A Roth IRA, established up in 1997, let’s you contribute to a retirement account now with after-tax money. So there are no deductions taken for your current taxes for contributions to a Roth IRA. But, you can withdraw the funds tax-free in retirement.

A SIMPLE IRA is for small businesses or employers that want to create savings plans for their employees. It follows the same rules as an IRA but the employees can decide if they want it pulled from their salary and the employer can decide to match contributions or put in another amount.

An SEP IRA lets employers of any size, including people who are self-employed, open and contribute to a traditional IRA for employees.

There is more to how IRAs work. Let’s dive into how much you can contribute and what happens to the money once it is in the account.

How does an IRA work?

As stated in the name, an IRA is supposed to be used for retirement savings and is to be opened by an IRS-approved financial institution.

The logic behind a Traditional IRA is that your tax rate is expected to be lower when you are in retirement. So not only do you get a tax deduction at contribution now when you put money towards an IRA, you can pay less in taxes on the money in retirement due to a lower tax rate.

ℹ️ Depending on the type of IRA, you can either deduct your contribution or you have already paid taxes on the contributions.

ℹ️ But, any earnings gained from the vehicles that your IRA invested in will be taxed at withdrawal.

You can decide, along with a financial advisor or professional, what the money does in the IRA account. It can be kept at a bank as a fixed deposit, or you can have an IRA that invests in stocks, bonds, mutual funds, exchange traded funds and other approved investments.

Understanding your own risk profile, tolerance and income needs can help you decide what to invest in.

And if your earnings grow in your IRA account from exposure to the market, you can expect to pay taxes on them.


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How do you qualify for an IRA?

As long as you are earning from wages, salaried work or qualifying income sources you can open an IRA.

But once you cross over the age of 70 ½ , you will no longer be able to open a new traditional IRA or contribute one. If you are earning income and are below the age of 70 ½, you can open and contribute to an IRA every year.

ℹ️ No matter how much your income is, a single person or filing jointly with a spouse, you can contribute to a Traditional IRA

Roth IRAs, however, can be opened at any age as long as you are earning taxable income. Even if you are in retirement.

For a SEP IRA, you can participate if you are over the age of 21, have worked for the employer for 3 of the past 5 years and earn at least $600 from the employer the past year.

SIMPLE IRAs require employees, or those self-employed to have earned at least $5,000 in compensation in the past 2 years and expects to receive at least $5,000 during the current calendar year.

For Traditional IRAs, your income and any existing employer retirement plans become a factor when it comes to the taxable deductions you can take. The IRS assesses your income by looking at your modified Adjusted Gross Income, or modified AGI.

If you are filing as a...If you are not covered by a retirement plan at work
Single or head of householdFull deduction for any amount of income
Married & filing jointlyFull deduction for any amount of income

If you do have a retirement plan at work, then your modified AGI will determine how much you can deduct from your taxes that year:

If you are filing as a...If you are covered by a retirement plan at work
Single or head of household earning less than $64,000A full deduction
Single or head of household earning between $64,000-$74,000A partial deduction
Single or head of household earning more than $74,000No deductions

For married spouses who are filing jointly or qualifying widowers, and are also covered by an employers retirement plan, the qualifying modified AGI for deductions are as follows:

If you are filing as a...If you are covered by a retirement plan at work
Married & filing jointly earning less than $103,000A full deduction
Married & filing jointly earning between $103,000-$123,000A partial deduction
Single or head of household earning more than $123,000No deductions

For Roth IRAs, there is a maximum Modified AGI limit to be able to open and contribute:

If you are filing as a...The maximum Modified AGI allowed
Married Couple filing jointly$205,999
Married but filing separately and not living with your spouse$138,999
Single$138,999
Qualifying widower$205,999

How do I get an IRA account?

You can open an IRA with any of the following that offer individual retirement accounts:

  • Bank
  • A federally insured credit union
  • A savings and loan association
  • Mutual Fund Company
  • Life Insurance
  • Through a stockbroker

Some firms may offer online IRA account openings, especially if you are already a banking customer or have an existing relationship. Check to see if there are IRA options available online with your online financial institution.

Whether you open an account online or in person, you will need to provide details on how you would like the funds allocated as well as beneficiary designations.

For SEP or SIMPLE IRAs, you will need to check with your employer to get started.

For Traditional IRAs, you will also need to sign the documents and disclosures allowing for:

  • The financial institution to be the trustee or custodian of your IRA
  • Contributions can’t be more than the annual allowed deductible amount
  • Contributions must be in cash
  • You have a non-forfeitable right to your IRA
  • You will receive distributions at 70 ½

Roth IRAs will require similar details, but will also require disclosure statements to be signed.

Contributing to your IRA

You can open and contribute to a new IRA as long as you are:

  • Earning taxable compensation
  • Below age 70 ½ for traditional IRAs
  • At least 21 years old for SEP IRAs

First, your contributions to an IRA must be from taxable earnings.

So normally that is from income from wages, salaries, commissions, self-employment income or maintenance and alimony income. Roth IRA contributions, specifically, will be made from post-tax earnings.

Second, contributions to an IRA must be made from cash, and can not be made from:

  • Earnings and profits from property
  • Interest or dividend income
  • Annuity or pension income

The IRS designates that there is a maximum amount that can be contributed every fiscal year:

Your ageMaximum contribution limit
Below age 50$6,000
Above age 50$7,000

You are not required to contribute to an IRA every year, even if you have one open. But keep an eye on the maximum contribution limits, because they can change annually as well.

In case you have contributed more than the maximum limit in a year, you can allot the excess to another year with less contributions. There may be fees and additional taxes however.

But in turn, you are not able to make up for past year contributions, but again, you are able to contribute $1,000 more annually once you are over 50 years old.

Withdrawing from your IRA

A traditional IRA, SEP IRA or SIMPLE IRA requires distributions, or withdrawals, starting April 1st after you turn 70 ½. This is called a Required Minimum Distribution, and is distributed every year.

Remember, your distribution and earnings in a traditional IRA will be taxed when taken as income in your retirement.

Roth IRA distributions are not required at age 70 ½ and taxes are not paid on contributed amounts.

If you would like to withdraw from your IRAs before age 59 ½, you will be hit with a 10% early withdrawal penalty fee. But there are a few exceptions.

You can take early withdrawals from your account for the following reasons:

  • Total or permanent disability
  • Qualified education expenses
  • If you are buying your first home
  • Unreimbursed medical expenses
  • Military service

Sources

This publication is provided for general information purposes only and is not intended to cover every aspect of the topics with which it deals. It is not intended to amount to advice on which you should rely. You must obtain professional or specialist advice before taking, or refraining from, any action on the basis of the content in this publication. The information in this publication does not constitute legal, tax or other professional advice from TransferWise Limited or its affiliates. Prior results do not guarantee a similar outcome. We make no representations, warranties or guarantees, whether express or implied, that the content in the publication is accurate, complete or up to date.

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