So, what is it exactly? We don’t mean to be biased, but this is an important one. If you open a single account with us, or another investment company (but really, hopefully us), we think an IRA is a great one to start with.
The Individual Retirement Account (IRA) is what it sounds like: an account used for the purpose of saving and investing money now so you can take it out later when you retire. (Please, not before you reach retirement age unless you really, really need to. More on that later.) The government introduced the IRA in 1974 as part of the Employee Retirement Income Security Act because they wanted Americans to be better about investing our money. Which is in the government’s best interest—otherwise it would fall to them to take care of us financially in our dotage.
A traditional individual retirement account (IRA) allows you to invest pretax income. (There’s an asterisk, though. More on that in a bit.) Transactions in the account are not subject to tax while still in the account, but are subject to federal income tax upon withdrawal. The IRS sets an annual limit on contributions. In 2018 it’s set at $5,500 (or $6,500 if you’re over 50).
What are the pros? Besides taking care of your future self, if your IRA contribution is deductible you will get a smaller tax bill now. The advantage of this is you don’t have to pay income taxes on the money you put into your IRA until that money is withdrawn (hopefully while you’re still young enough to enjoy having been such a responsible investor). So that’s the beautiful part—the government is essentially lending you money to invest with. You’ll be making compound returns on funds the government would have otherwise collected.
Once you are eligible for penalty-free withdrawals after the magic age of 59½ (apparently the IRS counts birthdays like children?), your withdrawals will be taxed like regular old income. If you decide you don’t need to start taking withdrawals starting at age 59½ you can let your account keep growing. However, Traditional IRAs require you to start taking withdrawals at age 70½.
Is there anything to be careful about? Early withdrawals. If you find yourself in a tight financial situation and need to dip into your piggy bank before you hit that 59½ milestone, you may have to pay dearly in the form of a 10% income tax penalty (i.e., you’ll pay income tax on the withdrawal at the normal rate, plus another 10%). That is, unless you qualify for an exception.
And when you’re doing your retirement math, don’t forget that you will eventually have to pay income tax on that money in the year you withdraw it. Additionally, Traditional IRAs require you to start taking withdrawals (called “required minimum distributions”) at age 70½. You can find more information about Traditional IRA required minimum distributions on the IRS website.
You can contribute to a traditional IRA whether or not your participate in another retirement plan through your employer or business. The government sets a limit for how much money you can contribute every year tax-free, so your deduction may be limited on your traditional IRA contributions if you or your spouse participates in another retirement plan at work.