An Individual Retirement Account, or IRA, is a tax-advantaged investment account that can be used to save for retirement. Money that you contribute to an IRA is usually tax-deductible, but you will pay taxes when you reach retirement age and withdraw the funds. IRA funds may be invested in stocks, bonds, or mutual funds.
Your employer may offer an IRA plan, or you may set one up yourself. Some employers may offer to match all or part of your contributions. Check with your employer to see what they offer because the matching amount can be a significant boost to your IRA.
Tax deduction on Traditional IRA
If you or your spouse have access to a different form of retirement savings, such as a 401(k), through employment, you may not be able to deduct the full amount of your IRA contribution. The IRS guidelines are here.
A Roth IRA is a type of IRA with different tax rules. When you invest in a Roth, you do not deduct those amounts from your taxes. Instead, you pay taxes on the money you invest. When it’s time to withdraw the funds, you withdraw them tax-free.
To contribute to a Roth IRA, your income must meet certain requirements. This chart explains how to determine if you can contribute to a Roth based on your income. Though you do pay taxes on your contributions now, since your money grows tax-free, you’ll have more available funds when you retire.
For 2020, annual maximum contributions to IRAs and Roth IRAs are $6,000. If you are age 50 or older, you may contribute up to $7,000 for the year.
Setting up your IRA
If you don’t have an IRA through your employer, you can set up your IRA or Roth through an IRA broker, a financial advisor, and maybe even at your bank. It’s easiest if you can make automatic contributions each month, so before you set it up, take some time to work on a budget and determine how much you’d like to contribute each year. Divide that into twelve to determine how much to contribute each month.
How much to invest
A good rule of thumb when saving for retirement is to save 10% to 15% of your income. However, if you’ve started saving for retirement later in life, it might be wise to save more. There are a few things you should consider to determine the amount that’s right for you.
Start saving for retirement as early as you can. When you begin your professional career in your twenties, saving for retirement is probably the last thing on your mind. You also probably have a lower income because you aren’t experienced in your job yet, and you have expenses such as buying a home and having children.
However, the time value of money is almost unbelievable when you look at the math. Six thousand dollars invested at 10%, which is the average stock market return, could be worth:
- $15,562.45 in ten years,
- $40,365.00 in twenty years,
- and a whopping $104,696.41 in thirty years.
And that is just contributing the maximum IRA contribution of $6,000 one time, and sitting back and watching it grow! Based on these numbers, you can see that the sooner you begin saving for retirement, the longer your money has a chance to grow. Saving in your younger years when money is tight is difficult, but you’ll be thanking yourself in thirty or forty years as you reach retirement age!
Even if you’re older, it’s not too late to start. Maximize your contributions if you can, take advantage of employer matching, and speak with a financial advisor to see if there’s anything else you can do to help you save up more quickly.
Early withdrawal and required distributions
There may be penalties for withdrawing funds from your IRA before reaching the age of 59 ½, but there are exceptions if the money is used due to certain hardships such as job loss. Once you’ve put your money in, it’s best to leave it there unless you absolutely must have access to it.
Additionally, IRAs are subject to minimum distributions. Once the owner of the IRA reaches age 70 ½, they must begin taking withdrawals.
The tax advantages of both Roth IRAs and traditional IRAs make them excellent vehicles for retirement savings. Whether you utilize an employer or set an account up on your own, saving for retirement is an integral part of planning for your future.