Understanding IRAs

IRAs for Beginners

An individual retirement account (IRA) allows you to save money for retirement in a tax-advantaged way. while most people are familiar with the basic concept behind an IRA, many don’t understand how they actually work. Let’s take a deeper look…

No matter where you are with your retirement savings, an IRA gives you the ability to have more investment options and choices.

An individual retirement account (IRA), as the name implies, is a place to store savings for the golden years. These accounts offer tax-advantaged retirement savings. You can choose from a traditional, Roth, SEP or SIMPLE IRA.

The earlier you start an IRA, the better. But even when you’re close to retirement, opening this special retirement savings vehicles can still make sense under some circumstances.

Here’s what you need to know about investing for retirement in an IRA.

What exactly is an IRA?

As mentioned, an individual retirement account (IRA) is a tax-deferred investment account that helps you save for retirement. Investing in an IRA allows your money to grow and compound.

All types of IRAs work in the same way. Money contributed to the account can be invested in a variety of stocks, bonds, ETFs, mutual funds, and other investment vehicles. Because these investments are usually tax deferred, it means that dividends and interest income received within an IRA aren’t included in the owner’s income each year, and any capital gains are deferred from taxation; Which is why IRAs are a great opportunity for anyone who’s nearing retirement and looking to boost their savings.

Generally, you (or your spouse) must have earned income to contribute to an IRA. There are also withdrawal rules: You may face a 10% penalty (which we go further into below).

There are two main types of IRAs; traditional and roth. Both are great for various reasons, it’s ultimately up to the individual to choose one that works better for them. Here’s a breakdown of the two key kinds of IRAs and what they have to offer.

Traditional IRA

When you contribute to a traditional IRA, the money in the account is tax-deductible. If you’re not covered by a retirement plan at work, you can deduct your entire contribution to a traditional IRA. If you are covered by such a plan, your contribution may be partially deductible—depending on your income and filing status.

Your investments are allowed to grow and compound on a tax-deferred basis, so you won’t have to pay capital gains and dividend taxes year after year. Once you withdraw the money, it’s treated as income and may be taxable.

The contribution limit for traditional IRAs in 2022 is $6,000 per year. People 50 and older can contribute up to $7,000 per year.

Roth IRA

With a Roth IRA, you get a tax break on tax-free withdrawals. Roth contributions aren’t tax-deductible and they don’t come with any special requirements for eligibility. This is because Roth IRAs are funded with after-tax dollars, so there’s no need to claim a deduction in order to get the money into your account.

In addition to these rules, though, there are income limits that determine whether you can contribute at all, regardless of whether or not you have a retirement plan at work. These limits are set by the IRS and detailed in Publication 590-A. In 2022, the annual Roth IRA contribution limit is $6,000 ($7,000 if 50 or older) for modified adjusted gross incomes below $144,000 for single filers and head of household, or $214,000 for married people filing jointly. The amount you can contribute phases out depending on how much you earn. Keep in mind that the contribution limit for Roth and traditional IRAs is a combined limit; if you have both types of IRA, you can contribute only the maximum between them.

Note, too, that married couples who file their taxes jointly can often fund two IRAs—even if only one spouse has a paid job—using what’s known as a spousal IRA. Publication 590-A provides those rules as well.

Other IRAs to Consider

In addition, there are two specialized types of IRA designed for small businesses and the self-employed. 

Sep IRA

If you’re a small business owner looking to give your employees a simple but valuable benefit, the SEP IRA is relatively easy to set up and administer.

The Simplified Employee Pension (SEP) is a retirement plan that lets self-employed and small business owners make a tax-deferred retirement contribution to the plan on behalf of each employee.

Contribution limits are higher than with Traditional or Roth IRAs – up to 25% of each employee’s pay, or. $61,000 for 2022 ($58,000 for 2021; $57,000 for 2020 and subject to annual cost-of-living adjustments for later years).

Simple IRA

Big corporations use retirement plans like the 401(k) (more below) to attract and keep good employees. Whether you are self-employed or if you have up to 100 employees, the SIMPLE IRA may give you big-time retirement benefits without the big-time start-up and operating costs.

Employees can make contributions, and employers also contribute to SIMPLE IRAs on their employees’ behalf. The tax structure of a SIMPLE IRA is the same as that of a traditional IRA, meaning contributions are tax deductible but withdrawals will be considered taxable income.

The amount an employee contributes from their salary to a SIMPLE IRA cannot exceed $14,000 in 2022.

What About a 401(k)?

IRAs and 401(k) plans are both great investing tools with different strengths.

Both 401(k)s and IRAs have valuable tax benefits, and you can contribute to both at the same time. The main difference between 401(k)s and IRAs is that employers offer 401(k)s, but individuals open IRAs (using brokers or banks). IRAs typically offer more investments; 401(k)s allow higher annual contributions.

If you haven’t already maxed out your 401k, now is a good time to do so. These plans are great ways for you to save and invest automatically and you can defer paying taxes on the income until you decide to withdraw.

The maximum amount you can contribute to your plan is adjusted each year to reflect inflation. In 2022, it’s $20,500 for anyone under age 50. But once you’re 50 or older you can make an additional catch-up contribution of $6,500 for a grand total of $27,000. If you have more than the maximum to sock away, either a traditional or Roth IRA could be a good option.

Contributing more than the maximum amount will not affect your eligibility for Social Security retirement benefits or Medicare coverage. You will also not be taxed on any money contributed beyond these limits until you withdraw it.

At the end of the day, whether a 401(k) or an IRA is better for an individual depends on the individual. A 401(k) allows for more money to be contributed each year on a pretax basis than an IRA. However, an IRA tends to have more investment options. Note that an individual can have both.

Beware of Penalties

The IRS allows for a rollover or transfer of your funds from a 401(k) to an IRA. However, the process and guidelines outlined by the IRS must be followed so that the IRA transfer doesn’t count as a distribution, which could incur a penalty. The easiest way to make sure funds roll over penalty-free is to do a direct rollover.

There are further penalities in this sector to be aware of. Are you planning to take a lump-sum distribution from your retirement account? If so, you should know that it’s not the best idea. If you take money out of your retirement account before age 59½, you will be subject to a 10% early withdrawal penalty—and that’s on top of the taxes that you’ll have to pay on the money itself. However, after the age of 59½ you can begin making withdrawals from your retirement savings account without any penalties. 

With a Roth IRA, you can withdraw your contributions—but not any earnings on them—penalty-free, at any age. There is one exception that the IRS has to offer. It’s called the Rule of 55, and it waives the penalty on early distributions from retirement plans if you lose or leave your job. It’s complex, so speak with a financial or tax advisor if you are considering using it.

Ultimately, it’s tempting to take money out of your retirement accounts when you have the chance. But if you can avoid it, you’ll be much better off in the long run. 

Final Thoughts

When you’re ready to start setting aside (or withdrawing) money for your retirement — whenever that might be — take a look at the valuable benefits of each of these types of retirement plans.

You should start planning well before the important age of 72 (when you can start withdrawing) to avoid having to make sudden moves with an IRA, and to determine how to best allocate these funds for maximum income and minimum taxes. If in doubt, ask your trusted financial advisor for help.

APO Financial is a full-service retirement planning firm, offering our clients the guidance they need to build a sustainable income plan. Our financial advisors are highly experienced in IRAs and other investments, and equipped to handle any of your retirement needs. 

Our goal is to demystify investing while helping you build real-life, holistic, sustainable income plans for your retirement. We understand that planning for retirement can be overwhelming—that’s why we’re here to help! Contact us today for more information on our retirement planning services.

Investment advice is offered through APO Financial Services, LLC. Insurance and fixed annuity products are offered through our affiliates, Asset Protect One, Inc. and/or APO Financial Services, Inc. No persons associated with APO or its affiliates is a licensed attorney or tax professional and nothing on this Page should be considered tax or legal advice.
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