IRAs are tax-advantaged accounts that can hold your retirement investments. It's easy to get intimidated by IRAs.
Here is an example of a common email we receive on the subject of IRAs:
“I'm going to open a Roth IRA on my own, and I'd like to know what online sites you or your readers would suggest. I want to invest in index funds, having heard they are the bee's knees, but books and the web, and magazine articles are sadly silent on the HOW, spending lots of time on the WHY.
“Right now I'm looking heavily at e*trade and ING. I need to know more about Roths before I make my final decision, although ING is looking the best right now. Vanguard sounds good, but that $3,000 minimum is a problem.”
Individual Retirement Account — What is an IRA?
The technical term, according to the Internal Revenue Service, is an Individual Retirement Arrangement, though it is more commonly called an Individual Retirement Account or IRA.
An IRA is simply a holding account. It's a label. The difference between an IRA and an ordinary investment account is twofold:
- Your contributions to your IRA may be deductible for income taxes. (More details below.)
- All the gains (dividends, interest, and capital gains) accumulate untaxed as long as they stay in the account.
Related >> How to Start a Roth IRA
When you open an IRA, it contains nothing. It's like a bucket — it's just a place for you to put something — and what you place in your bucket are investments. For example, you might buy stock through your retirement account or maybe government bonds. Some people use their IRAs to buy real estate; and some simply let their cash sit there, earning interest, just as it would if it were deposited in the bank down the street.
Smart people mix things up over time. Their buckets may contain a combination of stocks, mutual funds, bonds, and real estate. But they don't have to be diversified at all. Your IRA can contain a single index fund if that's what you want to do.
But just remember: An IRA is not an investment — it's a place to put investments.
What is the Benefit of an IRA?
The primary benefit of an IRA is that the returns on an investment are not taxed.
Untaxed, the gains earned in an IRA compound much faster compared to an ordinary investment account where what you earn is taxed every year.
In addition, depending on the type of IRA you set up, either your withdrawals (Roth IRA) or your contributions (traditional IRA) are not taxed. Over your lifetime, a tax-favored personal savings arrangement, or IRA, can add tens of thousands of dollars to your balance which you may not have had otherwise. It's a benefit the federal government offers workers to encourage them to save for retirement, and the advantage is significant enough that it shouldn't be overlooked.
Types of IRAs and Their Tax Advantages
There are two major types of IRAs — a traditional IRA and a Roth IRA. In order to understand the difference, let's first step back and look at a normal investment account, i.e., one with no tax advantages.
Normal Investment Account (no tax advantages)
When you use a non-retirement account, you invest post-tax money, meaning that you have already paid taxes on that income and you invest some of what is left over after taxes. Depending on how you invest, you may also be taxed on the interest, dividends, and all other gains along the way. You will also be taxed on any appreciation when you sell your investment.
As compared to a normal investment account, investing through an IRA has three different tax implications:
Traditional IRA – With a traditional IRA, you can deduct the money you invest from that year's taxes, but you will pay taxes on any withdrawals you make from the account.
- Your contributions (i.e., the money you invest) will be tax-deductible.
- All gains (i.e., interest, dividends, and capital gains) will not be taxed as long as the money remains in the account.
- When you withdraw the funds after age 59 ½, you will pay normal income tax on the amount you withdraw.
Roth IRA – With a Roth IRA, you invest money that you have paid taxes on, but your withdrawals are not taxed.
- Your contributions are not tax-deductible.
- All gains (i.e., interest, dividends, and capital gains) will not be taxed as long as the money remains in the account.
- When you withdraw the funds after age 59 ½, you will not pay income taxes on the amount you withdrawal.
We will discuss when it makes sense to choose one or the other in a following post. For now, all you need to know is the primary difference between the two major types of IRAs.
In addition to the two types of IRAs, you can also open an Individual Retirement Annuity account. In general, those are structured like conventional IRAs, but there are limitations as to who the beneficiaries might be. The premiums have to be flexible in order to allow for lower limits in future years and count toward the IRA contribution limit. In other words, it's an IRA investing in a specified investment vehicle (annuities), but it has to be in a separate account.
IRA Restrictions
Below are a few general limitations. You can get full details, written in clear language, from the IRS website by typing “590-A” in your favorite search engine. Chapter 1 will deal with traditional IRAs and Chapter 2 with Roth IRAs.
1. Not everyone can open an IRA account. In creating IRAs, the government specifically intended them for people who work for a living. Having a job, therefore, is the number one requirement to qualify for an IRA. Very wealthy people or retirees who live off their investments can't open one. Once you do open an IRA account, you can keep it as long as you live.
2. There are contribution limits. For 2015, your total contributions to all of your traditional and Roth IRAs cannot be more than $5,500 — it's $6,500 if you are 50 years of age or older — or your taxable compensation for the year, if your compensation was less than this dollar limit. (These amounts change annually, so it's worthwhile to check the Form 590-A website referred to above.)
- The IRA contribution limit does not apply to 401(k) rollover contributions and qualified reservist repayments.
- For married couples, each spouse figures his or her limit separately, using his or her own compensation. This is the rule even in states with community property laws.
3. You can contribute to an IRA even if you contribute to a 401(k) or similar retirement plan at work. However, once your income goes over $60,000 (single) or $96,000 (joint), limitations kick in. The IRS Form 590-A web page spells out the various scenarios clearly with two tables (Table 1-2 and Table 1-3 if you're looking for them).
If neither you nor your spouse has a work retirement plan, there is no reduction in your contribution limit.
4. There is an annual cut-off date. You can't make contributions for a given year after April 15 of the following year. You are not obligated to make a contribution every year, but you can never catch up once you have passed the cut-off date.
5. Your IRA can't invest in things that are under your control, like your business. The restrictions are few — you can, for instance, invest in real estate — but as a general rule, the things you invest in cannot be connected with you (like your home or your business). You also can't sell property to it or buy property for your personal use.
6. You can't borrow from your IRA or use it as security for a loan.
7. Your IRA can't invest in collectibles, with the exception of gold coins minted by the U.S. Treasury.
When you engage in what the IRS calls prohibited transactions, your IRA will be reclassified as a regular account and you will be taxed as if you made a complete withdrawal on the first day of the year.
Where to Open an IRA
Because an IRA is technically just another investment account, thousands of institutions that offer investment accounts also offer IRAs. Each has its advantages and disadvantages.
- Many banks and credit unions offer IRAs, but they may only allow the money to be used for certificates of deposit or money market accounts.
- Big-name mutual fund companies like Vanguard are great places to open an IRA, but they often require a minimum initial investment of several thousand dollars and provide a limited universe of investment choices.
- Discount brokerages like Sharebuilder and E*trade allow new investors to begin saving for retirement with no minimums, and they usually have smaller fees or no fees at all.
There is no one right place to open an account. You will need to search for a place that is good for you. (I explore some options in Part 2 of the Introduction to Roth IRA Series.)
Questions to Ask as You Research Where to Open an IRA:
- Is there a minimum initial investment?
- What fees are assessed to the account?
- Does the company offer automatic contributions?
- What are the limits?
- What investment options are available?
- Stocks?
- Mutual funds?
- Real estate?
- Is it possible to download statements automatically into Quicken?
Remember: The perfect is the enemy of the good. It is far better to open a Roth IRA now through any provider than it is to delay because you are worried about finding the very best place. Do your research. When you find a place that meets your requirements, open an IRA. Don't fuss and fret, worrying about whether or not it really is the best choice. Find a good choice and go with it.
The GRS Introduction to Roth IRAs Series
Check out the rest of our Roth IRA series to learn more about how to start your Roth IRA, which investments are best, and other general questions about these great accounts.
Part 1: The extraordinary power of compound interest
Part 2: What is a Roth IRA and why should you care?
Part 3: How to open a Roth IRA (and where to do it)
Part 4: Which investments are best for a Roth IRA?
Part 5: Questions and answers about Roth IRAs
The Bottom Line
Don't be afraid of IRAs. With a little homework you can add these valuable accounts to your retirement strategy.
