An IRA, or Individual Retirement Account, is a tax-advantaged account that allows you to save for retirement. IRAs are a great way to build your financial future. They offer tax benefits, flexible contribution options, and the potential for long-term growth.
It’s important to understand how IRAs work so you can make the most of your savings and maximize your retirement income. So, if you’re looking for ways to make your money work for you and save as much as possible for retirement, keep reading. We’re explaining how IRAs work, discussing contribution limits, looking at the types, and assessing the pros and cons.
How Does an IRA Work?
Contributions to an IRA are typically made with pre-tax dollars, meaning you can deduct the amount you put in from your taxable income, reducing the taxes you owe. In addition, earnings in an IRA grow tax-free until withdrawn, at which point they’ll be taxed as ordinary income.
Contribution limits
IRAs have annual contribution limits. For the 2022 tax year, the maximum amount you can contribute is $6,000 if you’re under 50 and $7,000 if you’re over 50 (not this amount will go up to $6,500 and $7,500, respectively, in 2023).
It’s also important to note that this limit applies to both Traditional and Roth IRAs combined. However, spouses or partners can each have their own accounts that can be maxed out individually.
Can you withdraw money?
The answer is yes, but certain conditions must be met for withdrawals to be penalty-free. Generally speaking, 59 ½ and older individuals can make IRS penalty-free withdrawals from their IRA accounts, but must be declared as income on your taxes. However, if you take out funds before reaching this age, you may face a 10% early withdrawal penalty, and that’s on top of any taxes due on the amount withdrawn.
There are exceptions to the 59 ½ rule. You might qualify for penalty-free early withdrawal or hardship deductions if any of the following apply to your circumstances or condition:
- Premiums for health insurance while unemployed
- Permanent disability
- Up to $10,000 towards purchasing a first home
It’s important to note that these exceptions only apply when taking money out of traditional IRAs; Roth IRAs have different rules regarding early withdrawal penalties
IRA Benefits and Drawbacks?
Wondering: what is the tax advantage of an IRA? There are both pros and cons to IRAs. Understanding them will help you become a savvy investor and saver.
Benefits
IRAs are a popular retirement savings option for the benefits they offer. IRA benefits include:
- Tax-deductible contributions
- Earnings grow tax-free until withdrawn at retirement age
- No minimum balance requirements or fees associated with setting up
- Withdrawals after age 59 ½ may not be subject to early withdrawal penalties – making them more accessible than other types of retirement accounts like 401(k)s and 403(b)s which have higher restrictions around accessing funds before reaching full retirement age (59 ½)
Drawbacks
Of course, there are always drawbacks to any investment strategy. One of the biggest is contribution limits. In 2022, individuals under 50 can only contribute $6,000 annually; those over 50 can contribute up to $7000. Additional cons include:
- Contribution limits apply across all traditional and Roth IRAs held by the same owner – if you have multiple accounts, you must spread contributions accordingly
- No employer matching option
- Withdrawals taken prior to 59 ½ could trigger hefty fines plus taxes
Types of IRAs
Different types of IRAs can offer varying solutions depending on your needs and financial goals. You should understand the basics of each before opening one.
Traditional IRA
A Traditional IRA is a retirement savings account that allows you to save pre-tax dollars for your future. Contributions are tax-deductible, and the earnings grow tax-deferred until withdrawal. Only then are they taxed as ordinary income.
- Contributions are tax-deductible
- Limits on annual contribution amounts
- Age and income level based
ROTH IRA
A Roth IRA is another type of IRA that allows you to save after-tax dollars for your future. The contribution limit is also based on age. The main difference between traditional and Roth IRAs lies in their taxation structure.
- More flexibility in withdrawal options
- Contributions are not tax deductible, but earnings grow tax-free until withdrawal
- If certain conditions are met, earnings can be withdrawn without any taxes or penalties
SIMPLE IRA
SIMPLE IRAs are a tax-advantaged way for small business owners to offer retirement plans for their employees.
- Convenient for small business owners
- Good for businesses with less than 100 employees
- Allow matching
SEP IRA
Simplified Employee Pension (SEP) IRAs allow business owners to make contributions directly into their employees’ accounts up to 25% of their yearly salary or $61,000 (in 2022). The contributions made by the employer are considered taxable income for the employee. However, any growth will remain untaxed until withdrawn at retirement age.
- Follows the same investment, distribution, and rollover rules as traditional IRAs
- Any employer, including self-employed individuals, can establish a SEP
- Can have a SEP in addition to a ROTH
Rollover IRA
Rollover IRAs let you move funds from another retirement plan (for example, a 401k) while maintaining the tax benefits without paying any early withdrawal penalties or current taxes.
- You have 60 days from the date of distribution to roll funds into a Rollover IRA and avoid a penalty
- Can roll over as much as you want (no limit to opening)
Beneficiary IRA
Beneficiary IRAs are inherited IRAs that pass from an original IRA owner to a beneficiary at the time of the original owner’s passing.
- Most workplace plans can be transferred to inherited IRAs – including: 401(k) plans, traditional, SEP, and ROTH IRAs
- Upon opening a beneficiary IRA, the balance will continue growing tax-deferred
- Potential to make immediate, penalty-free withdrawals
Final Thoughts
What is an IRA account? Ultimately, IRAs are a great tool to save for retirement. They offer many benefits, like tax-deferred growth, potential tax deductions, and the ability to choose from different types of investments.
Are you looking for a reliable and secure way to save for retirement? Look no further than Island Federal Credit Union – our IRA accounts offer competitive rates, tax-deferred growth, and flexible withdrawal options. With our knowledgeable staff and personalized service, we can help you find the right retirement savings solution that fits your needs.
Start planning for your future today with an IRA account from Island Federal Credit Union – reach out today to get started.