How Do IRAs Work?
Raise your hand if you’ve ever heard the phrase “it’s never too early to start saving for retirement.” Okay, you can put your hand down now.
Yes, you’ve likely come across this ubiquitous phrase at some point or another. I definitely have. Actually, I have heard it every year since I turned 18. Typically it comes up at a family gathering or as some aside from a professor during a lecture. And like most of my fellow millennials, I put that advice about having a retirement plan on the back burner, assuming I would just wake up one day and figure it out. Besides, I couldn’t be bothered with saving for the future. I mean, that entire box set of Friends wasn’t going to watch itself (for the sixth time).
Why you need to prepare for retirement
That is, until I got an internship at a financial tech startup. Saving and preparing for retirement is a very important part of “adulting.” The problem is, even after you know you’re supposed to do it, it’s hard to know how to do it. There is such an overwhelming amount of information out there about where to invest, in what, and how much, that it’s hard to know where to start. It’s easier to just keep putting it off for your future self.
But, you’re not Ted Mosby, and with this basic guide to retirement savings, you won’t want to keep putting it off anyway. You’ll learn the basics of where and how to start financial planning so you can ensure your future self is taken care of.
And it all starts with the IRA.
What is an IRA, and how do IRAs work?
IRA stands for Individual Retirement Account. How do IRAs work in comparison to 401(K)s — which you’ve likely also heard about? Whereas a 401(K) is set up by your employer and managed through them, an Individual Retirement Account is set up by you and managed by the financial institution of your choosing. Unlike the 401(K), there are two different kinds of IRA to choose from — the traditional and the Roth.
How do I decide on which type of IRA is right for me?
The type of IRA you want will depend on your lifestyle, earnings, and retirement expectations.
Traditional IRA
Traditional IRAs do not charge you taxes on the contributions you make to your account. There is a contribution limit for traditional IRAs. As an account holder, you’re allowed to contribute $5,500 each year if you’re under 50 and $6,500 if you’re over 50, tax-free, and you may even qualify for annual tax deductions on your contributions. The Traditional IRA also has no income limitations--meaning you can actively contribute to and hold your Traditional IRA regardless of what you make, as long as you are under 70 and have a taxable income. Your income may impact whether or not your contributions are deductible, though.
You are taxed, however, when you withdraw your money. Once you’ve hit 59 ½ and are ready to withdraw from your account, you will be taxed according to the tax bracket you are in at the time of your withdrawal. With the traditional, once you hit 70, you must start to withdraw from your account.
Roth IRA
The Roth IRA is similar — you can only contribute $5,500 a year if you are under 50 and $6,500 if you are over 50; you are eligible to begin withdrawing once you are 59 ½, and it is open to anyone with a taxable income.
Those are the similarities, but the Roth IRA has some very significant differences. The Roth IRA contribution limit is based on your modified adjusted gross income, depending on tax-filing status. With Roth IRAs, as an account holder you are taxed on your contributions, but not taxed once you reach retirement age and begin to withdraw from your account, and the contributions you do make each year are not tax-deductible. There is also an income limit of $132,000 for single income and $194,000 for joint incomes. But, there is no mandatory age when you have to start withdrawing for retirement.
What it really comes down to is whether you want to pay taxes upfront with your contributions, or once you begin to withdraw your money. If you expect to be in a higher tax bracket when you retire, then the Roth would make more sense since you would be charged more in taxes for your withdrawal than you would pay for your contributions. If you plan to be in the same tax bracket and exceed the income contribution limitation or prefer to have tax-deductible contributions, then the Traditional would be best for you.
How do I get one?
There are several places to set up an IRA. Choose a financial institution you trust--these can be banks where you have a checking or savings account, or online options like SoFi or Fidelity. Some places have required minimums to open accounts, so do your homework on how much it will cost you to open an IRA account.
What do I do once I have one?
Contribute the maximum amount to your account. You can add $5,500 annually, so try to hit that mark before the year is up to really take advantage of your IRA and prepare for your future. You’ll get the largest return on your investment if you’re putting in the full amount each year.
You can also indicate whether you want to have a beneficiary associated with your account. A beneficiary of an IRA will receive the benefits from the account if the account owner passes away (beneficiaries of an IRA are required to include taxable distributions they receive in their gross income).
Then what?
You wait and watch it grow. Your contributions will begin to earn compound interest, which means your money will be earning money until you are retirement age and ready to start withdrawing. Depending on which IRA you have, you can start drawing from your account once you’re 59 ½. If you have Traditional, you are required to start withdrawing once you’re 70.
How do you decide which type of IRA to get?
Ultimately, envision what you want your future to look like and then pick the IRA that works best for you so you can start squirreling away your money and have enough to live on when retirement comes. It’s not as hefty of a burden as maybe you expect. Just a few hundred dollars here and there will grow over time and lessen the stress when you’re older.
If you’re still unsure of which IRA works with your lifestyle and your financial goals, make an appointment with a trusted financial planner to go over your wealth, your lifestyle and your expectations to build a retirement plan that is unique to you.
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Alexandra Deabler is a writer and editor. She has published articles about California history, travel, lifestyle, personal essays and short fiction. She lives in New York City and can be reached through her website: alexandradeabler.com.
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