If you want to maintain your standard of living in retirement, experts recommend saving 10% to 15% of your income. You could stash it under a mattress, but the wiser move may be to put that money in an Individual Retirement Account (IRA).
With a traditional IRA, you don’t pay taxes on the money you contribute each month. Rather, you pay taxes on that money years later when you withdraw. These accounts are designed to encourage saving for retirement and come with a major benefit—they lower your tax bill today, reducing your taxes over your lifetime. With an IRA, you can deduct your contributions from your taxes each year, which lowers your adjusted gross income and your tax rate.
Of course, these accounts have some restrictions. You’ll pay a penalty of 10% if you withdraw money from these accounts before age 59 ½. And there are limits on how much you can contribute, depending on your income, marital, and employment status. Some accounts even require you to start withdrawing money at age 72, regardless of whether you need it.
Types of IRAs
1. Traditional IRA
With a traditional IRA, you put pretax money into a retirement account. You pay income taxes on withdrawals later. How much income tax you pay depends on your tax rate when you withdraw the money after age 59 ½.
You can contribute as much as $6,000 a year in a traditional IRA; those 50 or older can invest $7,000.
You’ll want to make sure you or your spouse aren’t covered by a retirement plan at work, however, as these plans can limit your ability to claim a full tax deduction.
2. Roth IRA
A Roth IRA is a retirement savings account that lets you contribute money after you’ve paid tax on it, not before. That is, you pay income tax on contributions when they’re made, not when they’re withdrawn in retirement.
The maximum amount you can put in a Roth IRA is $6,000 a year, and $7,000 a year for those 50 and older. If you file as an individual and your adjusted gross income is more than $125,000 but less than $140,000, that amount is reduced.
3. SEP IRA
Employers can set up a Simplified Employee Pension (SEP) IRA for employees who are 21 or older, have been with the employer at least three of the past five years, and were paid $650 or more in 2021.
SEP IRAs are designed for small businesses that don’t want the hassle (or cost) of a traditional 401(k), which requires more oversight. An employer can contribute 25% of the employee’s compensation or as much as $58,000 a year. All SEP IRAs are discretionary, so if cash flow is an issue, a business is not required to make an annual contribution.
You cannot withdraw from a SEP IRA without incurring a 10% penalty if you’re under age 59 ½.
4. SIMPLE IRA
Small businesses with 100 or fewer employees can set up a Savings Incentive Match Plan for Employees, or SIMPLE IRA. Both employers and employees may contribute, and employers must contribute, even if their employees do not. If an employee does contribute, the employer can either match his contributions dollar-for-dollar (up to 3% of the employee’s salary) or the employer can contribute the equivalent of 2% of the employee’s salary.
Let’s say you earn $50,000 a year and contribute 3% of your income ($1,500) to your SIMPLE IRA. Your employer can either match your contributions dollar-for-dollar, capped at 2% of the total.
An employee can put as much as $13,500 in a SIMPLE IRA. If an employee is 50 or older, he can make $3,000 in “catch-up” contributions.
What’s the difference between an IRA and a 401(k)?
A 401(k) is a retirement account offered through your employer. An IRA is a retirement account that you open on your own, unless it is a SIMPLE or SEP IRA. One advantage of a 401(k) is that an employer can also contribute, sometimes dollar-for-dollar.
Frequently asked questions about IRAs
How much money do I need to start an IRA?
You don’t need any money to open an IRA, but you must be younger than age 70 ½ and have some taxable income.
Can I have more than one retirement account?
Yes, but there may be limits on how much you can contribute and deduct from your taxes.
Imagine you have a 401(k) through your employer and a traditional IRA. You can contribute to both, however, if you make more than $66,000 a year and less than $76,000, you can’t claim a full tax deduction on the money you put in your IRA. If you make more than $76,000 a year, you can’t claim any tax deductions. As the IRS notes, these rules vary by marital status, retirement accounts, and household income.
Can I lose money in an IRA?
Once you’ve invested money in your IRA, you are vulnerable to losing money. When you open an IRA, you can decide how much risk you feel comfortable taking on.
What happens if I withdraw early from an IRA?
If you withdraw early from an IRA, you must pay taxes on the money you take out at your annual tax rate, plus a 10% penalty. There are some exceptions: You can withdraw early from an IRA to pay for education, and as much as $10,000 to help finance your first home. If you were adversely impacted by the Covid-19 pandemic, you may withdraw early from an IRA without penalty.
Are IRA contributions tax-deductible?
IRA contributions are tax-deductible, however, some situations may prevent you from claiming a full deduction. If you have a 401(k) and make more than $76,000 a year, for instance, you can’t claim a full deduction.
What happens to my IRA when I die?
When you die, your IRA goes to your beneficiary. The rules on what your beneficiary can do with your IRA may differ depending on who they are. If you designate your spouse, she may treat the account as her own (make contributions and withdrawals) or roll the money into her own retirement account.
If you designate someone else as a beneficiary, they may be required to drain the account according to a schedule. They could do so over five years or stretch out withdrawals over their lives. If you don’t select a beneficiary, your account goes to your estate, where it is subject to taxes.
The bottom line
An IRA is a powerful way to reduce your tax burden as you prepare for retirement. It lowers the amount of taxes you pay now so you can invest pre tax money for later. No retirement account is ever truly tax-free, but investing tax-free dollars and deferring taxes until you withdraw is a smart move to consider.