Basic Guide to Understanding Individual Retirement Accounts (IRAs)
Retirement is a significant milestone in everyone’s life and heralds a period of rest and relaxation after years of service in whatever industry. One of the best things that anyone can do for themselves is to plan for their sunset years. Retirement planning covers almost every aspect of one’s life but what seems to be the most important aspect for many is the financial aspect.
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You can either save or invest or do both and one of the ways of both saving and investing is through an Individual Retirement Account. IRA is the short form for Individual Retirement Account and it is a powerful financial tool that helps people save for retirement. These accounts offer different tax advantages that can increase the holder’s retirement savings.
A basic understanding of the different types of IRAs is essential for everyone whether they are at the beginning of their careers or close to retiring. Therefore this article will explore the different types of IRAs, their benefits and how to choose the right one for you.
What Is an Individual Retirement Account (IRA)?
An IRA is a type of savings account that lets the holder save and invest for their sunset years with tax advantages. Unlike conventional savings accounts, IRAs come with special tax advantages that make them beneficial and ideal for retirement savings.
These savings are not tools of investments in themselves but they are used to hold investments such as bonds, stocks, mutual funds and other assets. The major benefit of an Individual Retirement Account is the fact that it comes with many tax advantages that enables the funds to grow exponentially over time.
Types of IRAs
There are different types of IRAs and each comes with its rules/regulations, tax benefits and contribution limits. The most common types are as follows:-
Traditional IRA
This type allows you to fund the account with pre-tax income and this can reduce the income that will be taxed for the year. The contributions made into the account grow without being taxed until withdrawal at retirement. When you withdraw your funds from a Traditional IRA, the earnings are taxed just like a regular income.
This plan is recommended for people who envisage that they’ll be in a lower tax bracket when they retire. This is because the fact that the contributions were not taxed means that there is a possibility that the taxes you will pay at withdrawal will be lower.
Roth IRA
This account is funded with after-tax income; this means that the contributions are not taxed. However, the contributions grow tax-free and due for withdrawal when you retire and will also be tax-free. This can be quite advantageous for people who expect that they will be in a higher tax bracket when they retire.
One of the special features of this plan is that there no required minimum distribution during the lifetime of the holder. This enables greater flexibility for the management of the holder’s retirement income.
Other types of IRAs include:-
- SEP IRA – This stands for Simplified Employee Pension and is meant for small business owners and self-employed folks. The contribution limits are higher than the Traditional and Roth options. This option is best for people who want to quickly catch up with their retirement savings.
- SIMPLE IRA – Saving Incentive Match Plan for Employees is another variation of the afore-mentioned plan that is meant for self-employed folks and small enterprises. This is easier to set up and manage than other plans and that is why it is an ideal option for small businesses.
Tax Benefits of IRAs
One of the major reasons why people invest in IRAs is because of the tax benefits it comes with. The type of tax advantage you get depends on the type you choose. Find below some benefits:-
- Tax-Deferred Growth – This means that the account holder doesn’t pay taxes on the earnings from their investments until when they withdraw the money at retirement.
- Tax- Free Withdrawal – With Roth IRAs, you have tax-free growth as well as tax-free withdrawals. This is because the contributions are made with after-tax income.
- Tax Deductions – Contributions that are made to Traditional IRAs may be tax-deductible but it depends on whether you or your partner is covered by the plan and also on your income.
- No RMDs – Roth Individual Retirement Accounts unlike Traditional IRAs do not have Required Minimum Distributions (RMDs) in your lifetime. This enables your earnings to grow tax-free as long as you want.
Choosing the Right IRA
Choosing the right IRA is very important and there are factors to consider before making a choice:-
- Tax Situation – Your current tax situation is very vital to making a choice. If you are presently in a high tax bracket with an expectation of being in a lower tax bracket when you retire, then Traditional IRA may be the best option for you. This is because the contributions are taxed and therefore the earnings are not taxed. On the other hand, if you envisage that you will be in a higher tax bracket at retirement, then a Roth IRA is recommended.
- Income Level – The level of your income determines whether you are eligible for some types of IRAs. In case your income is more than the limit required for a Roth IRA, you may have to explore other options such as a gold IRA or consider a Traditional Individual Retirement Account. There is a plan that will most definitely work for your income level.
- Employment Status – There are different savings plans for different employment status, so choose the most appropriate for your employment status.
- Flexibility and Control – Look out for an account that is quite flexible and easy to manage/control.
Conclusion
An IRA like we have stated above is a very important tool for retirement planning. These accounts come with different tax advantages that help the account holder’s savings to grow exponentially over time. We have shared some information about these accounts that we believe will be of immense help you. Bear these tips in mind so that you can make an informed decision on the best option for your retirement savings.
