What is an IRA? How to Save for Retirement
Saving for retirement can be tricky. Start early, and it’s easy enough to let compound interest work its magic on your account. Start late, and, while it’s more work, it’s still possible to tuck enough money away to live comfortably. The major questions are: how to start an account, and what type of account you want to start in order to hit your retirement account goals. Let’s look at retirement accounts, how to open one, and all the information you’ll need to utilize your account to have money after you retire.
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How Much Do I Need to Save?
You will need to have money in the bank if you plan to retire comfortably. After all, unless you have a pension or wait for Social Security, you are aren’t guaranteed income. How much money should you save? In 2017, the estimated amount was about $738,000. For 2018, given inflation, it’s probably better to have closer to $750,000.
The general consensus is to save about 15 percent of your paycheck and invest it in a retirement account. Why, you may ask? The answer is simple: compound interest.
The concept of compound interest is fairly simple. You invest money into an account — we’ll expand more on this part in a moment. Those investments make money, called dividends, essentially your profit from your investments doing well. Instead of taking the dividends out and spending the money, it is reinvesting into the account.
You won’t miss the money, as you won’t exactly see it. It just serves to generate more and more money. The more money you have in the account, the more you make. If you start this process early in your career, it’s entirely possible that a few thousand dollars could turn itself into more than a million dollars. It’s never too early to start planning.
“That’s great!” you say. “How do I make the magic of compounding interest over multiple decades actually work for me?” Let’s talk IRAs.
What Is an IRA?
An individual retirement account (IRA) is basically a type of investment account. It’s not an actual investment, but rather a collection of investments. This can include individual stocks, bonds, index funds, or mutual funds. This account is setup through a financial institution, such as a brokerage firm. The goal is to save money for retirement. While the money can be withdrawn early, it’s meant to stay in the account and accrue compound interest over the lifetime of the account.
The key to IRAs are how they are taxed as you make contributions. This is what makes them different from simply investing in, for example, a portfolio of stocks. The exact way they are taxed depends on what type of IRA you open: A Roth, or a traditional.
Roth vs. Traditional IRA
Traditional IRA contributions are treated as “pre-taxed” during the contribution year. You don’t pay taxes on the money you save, it isn’t counted as income for tax purposes, and it essentially acts as a tax break. In short, the money you contribute can be deducted from taxes. If you are in a higher tax bracket right now than you will be when you retire, this is a great option.
On the other hand, Roth IRA contributions are made with post-tax dollars. You do not deduct these contributions from your taxes. Instead, you get a later payoff: you don’t pay any taxes when withdrawing after retirement. If you are in a lower tax bracket currently, this is a better option. However, as we’ll see later, not everyone is eligible for opening a Roth IRA.
There are a few rules for the tax-free withdrawal, however. The money can’t be taken out until you are at least 59½ years old. There are a few other events that can cause a penalty-free withdrawal, such as death, the purchase of a first home, or disability. Generally, though, putting in the time is your best option.
What is a 401(k)?
IRAs are 401(k)s, but a 401(k) is not an IRA. A 401(k) is an employer-sponsored retirement plan, while IRAs can be opened by an individual. An IRA can be part of a 401(k) with, for example, your employer matching contributions, often up to a certain percentage of your paycheck. Matching contributions cap out at $18,500 annually, though up to $55,000 can be contributed total.
If you have a 401(k) and leave the job, you can roll it over into a private IRA account. Rolling the employer-sponsored account into a private traditional IRA should not have any new tax implications, but rolling the money into a Roth IRA will result in being taxed as if you were simply making contributions. If you are converting a Roth 401(k) into a private Roth IRA, there should be no further tax implications.
IRA Contribution Limits
Just as there are contribution limits on a 401(k), there are contribution limits to an IRA. For both Roth and traditional IRAs, you can only contribute up to $5,500 per year. If you are 50 or over, you can contribute $6,500 per year. These limits do not apply to rollover contributions.
After you are 70½ years old, you can no longer make contributions to a traditional IRA. You can, however, make contributions to a Roth IRA, as well as make rollover contributions.
Early Withdrawal Rules
IRAs are created with a clear lifespan: Funds are not to be withdrawn until you are at least 59½ years old. If you withdraw any amount before then, you will be hit with a government-imposed 10 percent penalty.
There are some exceptions, however, including:
- Disability or death. If you become disabled, you will not be penalized for taking money out of your account. Likewise, should you die, your beneficiaries will not face the penalty.
- Medical expenses that total more than 7.5 percent of your income
- Education expenses for you or your immediate family
- Health insurance for yourself or your family, so long as you have been employed for 12 or more weeks
- Purchasing your first home, with a $10,000 withdrawal limit
Opening an IRA
Generally, anyone can open a Roth IRA, while you need to be under 70½ years old to open a traditional IRA. There are also income thresholds that limit who can make qualified contributions to IRAs.
Otherwise, you can open an IRA at most major financial institutions. Popular choices include Vanguard, E-Trade, Charles Schwab, and Wells Fargo. For a hands-on approach, you can work directly with your account and make changes yourself, choosing stocks, funds, and more as you see fit. You can also get a robo-advisor, that will handle deals for you, based on parameters you set.
Be sure you have your Social Security Number, birthday, contact information, employment details, and bank account details ready in order to open the account.
Private vs. Employer-sponsored
It’s even easier to open an employer-sponsored account. When you join a company, assuming the company offers a matching plan, HR will ask if you would like to make contributions. You may also have a financial advisor available through whichever institution the company uses. It’s possible that’s all you will have to do, with the advisor and your company taking care of the rest. In other cases, you will be able to make changes to the account yourself. It’s best to ask during your onboarding process with the company.
There are a few different fees you might run into when opening an IRA. There could be a flat opening fee, and you may need to have a minimum opening contribution. There might be an account fee per year, especially if you have access to a financial advisor or robo-advisor, that is a percentage of your dividends or account balance. There is also usually a fee per trade, typically between $5 and $20 per trade, sometimes depending on the account balance.
Before opening an account with a specific institution, research their fees, and whether they are acceptable to you.
It’s never too late to open up an IRA and start saving for retirement. The sooner, the better, but having any money tucked away to let compound interest work its mathematical magic is better than none. Consult a financial advisor for helping determining which type of account is best for you, and look forward to a retirement with money in the bank.
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A former newspaper journalist, Cole spends his free time reading, writing, playing video games, watching movies, and learning about every subject under the sun. He lives with his wife and daughter in Idaho. Follow Cole on Twitter: @ColeMayer42
This post was updated September 11, 2018. It was originally published September 12, 2018.