401(k), 403(b), TSP, SEP, Keogh - the world is overrun with retirement acronyms, but one of the most versatile and powerful is the Individual Retirement Account (IRA).
Bottom Line Up Front (BLUF)
- The Individual Retirement Account (IRA) allows a person to transfer a limited amount each year to a special account that grows partially tax-free.
- Unlike a 401(k), TSP, or other employer restricted account, an IRA is 100% under the control of the individual and allows investing in any stock, ETF, mutual fund, or bond a normal brokerage would.
- There are two types of IRAs - Traditional and Roth. The primary difference is when you pay the limited amount of taxes.
An IRA is essentially a clone of a normal brokerage account that has certain tax benefits in exchange for additional restrictions on when you can transfers and withdrawal funds. While taxes are still required on either the frontend or backend, assets within the account can grow tax free - with zero capital gains or income taxes on dividends.
This is a powerful multiplier that can outperform a standard brokerage account. In return, an investor can only deposit a limited amount each year ($6,000 in 2021), and is limited to withdrawing funds after retirement (special circumstances notwithstanding).
For this reason, the IRA is a perfect instrument to invest money that you will not need to access until retirement.
Traditional vs Roth
A Traditional IRA allows an investor to transfer in money "pre-tax", which means that every dollar you put into the account allows you to reduce the amount of income you pay taxes on that year. This tax deduction lowers the amount of taxes you pay today, however it means you will have to pay taxes on the money you withdraw from the IRA in retirement.
As an example, you earned $100 this year. You contribute $5 to your Traditional IRA. When filing your annual taxes, you would mark down you contributed the $5 to your IRA. This means the government would only make you pay income taxes on your remaining $95 in income. After 30 years you retire and finally pay taxes as you take the money out.
A Roth IRA (named after the person who invented it) allows an investor to transfer in money "post-tax", meaning without any tax deduction. In return, that money will grow until retirement and be disbursed back to you tax-free.
As an example, you earned $100 this year. You contribute $5 to your Roth IRA. When filing your annual taxes, you declare nothing and pay normal taxes. After 30 years you retire and begin to withdraw funds - and pay zero taxes on both your original contribution and the capital gains from 30 years of investing.
In essence, the choice is between whether you want to pay taxes now (Roth) or pay taxes in retirement (Traditional). Usually, a good strategy is to use the Roth IRA in your younger/lower-income years when you are in a lower income tax bracket and then shift to a Traditional in your older/highest income years. The overall goal of this is to pay as little in taxes as possible when you are in high tax bracket years, and instead offload the tax burden to either young or retired (and theoretically making less) years.
Opening an IRA Account
Either type of IRA can be opened at a normal brokerage just like any other investment account. This includes your brand name brokerages, traditional banks, and more specialized firms.
You can also view our rundown of the top online brokerages.
Registering usually only takes a few minutes, at which point you will be ready to add your first funds. However, remember that unlike a traditional brokerage your transfers in and out of an IRA account are subject to limitation. Only deposit funds you will not need access to until retirement.
The maximum annual contribution is listed below.
This sounds too good to be true right? Well there are a few limitations.
Contributions Per Year
There are limits on how much you can contribute each year, listed below:
|2021 Contribution Limits||Under Age 50||Age 50+|
|Traditional or Roth IRA||Up to $6,000||Up to $7,000|
You can contribute to any combination of Traditional or Roth if you wish, but the maximum cumulative total is capped at the above amount regardless of how many separate accounts or brokerages you use.
Traditional IRA Income Maximum
While anyone can contribute to a Traditional IRA, only people who make less than the below will be able to qualify for the tax deduction.
|2021 Traditional IRA||Single||Married|
|Deduction Phase-out||$66,000 to $76,000||$105,000 to $125,000|
|Non-deductable||Any income||Any income|
Note: If you or your spouse are not covered by a workplace retirement plan additional rules apply.
Roth IRA Income Limits
This is the limit for who can contribute to a Roth IRA. If you are above this, you do have the option of a "backdoor" contribution by contributing to a Traditional IRA and converting it to a Roth.
|2021 Roth IRA||Single||Married|
|Direct Contribution Phase-out||$125,000 to $140,000||$198,000 to $208,000|
|Backdoor/Conversion||Any income||No income|
Note: If you wish to pursue a backdoor contribution and have other/previous Traditional IRA assets there are additional rules.
Backdoor IRA Option
If you make more than the limit for a Roth contribution, the recommended option is to utilize the "Backdoor" Roth option. While neferiously named, it is an IRS endorsed method for high income earners to still participate.
The process is relatively simple:
- Open a Traditional IRA
- Transfer funds into the Traditional IRA
- Convert the Traditional IRA into a Roth IRA by contacting your brokerage
Note - If you already have a Traditional IRA from previous year(s), the conversion is subject to additional complications that must be worked with your brokerage. It is possible to convert an unlimited amount, however you will have to pay normal taxes on any amount that you previously took a tax deduction for.
One of the key advantages of an IRA over more restricted plans like a company 401(k) or government TSP is that you can invest in the vast array of stocks, mutual funds, ETFS, and bonds available on the full market. This allows you to customize your investing strategy for potentially higher (but riskier) returns.
The safer and arguably easier option is to invest in a portfolio of low-fee index funds. These provide diversified exposure to many different stocks and bonds which reduces the risk of one stock tanking and destroying your retirement account.
For example, Vanguard offers a range of highly rated (and low-fee) ETFs that are among the most popular in the world (for good reason):
- VTI - Vanguard Total Stock Market ETF
- VOO - Vangaurd S&P 500 ETF
- VDC - Vanguard Consumer Staples ETF
- VPU - Vanguard Utilities Sector ETF
- VTIP - Vanguard Short-Term Inflation-Protected Securities ETF
Each of the above are a collection of various stocks that offer different advantages and disadvantages. In general, they are ranked from most volatile (and highest performing) to least volatile (and lowest performing), however buying any of the above has historically been a good strategy over the long term.
IRAs are designed to have assets deposited until retirement, however there are a few exceptions that allow you to tax early withdrawals.
If you need to withdraw before age 59.5 for either Traditional or Roth, you may be subject to a 10% early distribution tax PLUS applicable income taxes. More importantly, because you can only contribute a limited amount each year to an IRA account, you will also loose out on the cumulative benefits of years of tax free growth that you simply can not deposit back later.
For this reason, it is HIGHLY recommended to never take out retirement savings early unless as an option of last resort in very extreme situations.
Other Types of IRAs
As this guide is intended for beginner investors, we do not cover the other types of IRAs. However for reference there are:
Simplified Employee Pension IRAs (SEP IRA) - for the self employed, similar to a Traditional IRA with higher annual contribution limits.
Savings Incentive Match Plan For Employees (SIMPLE IRA) - for small businesses and self-employed, similar to a Traditional IRA fused with a 401(k) type employer contribution.