An individual retirement account (IRA) can be an important part of retirement investing. But before investors save money in this type of plan, it makes sense to know the basics about who it’s for, how it can help, and which type of IRA is right for you.
This article will cover the seven most common questions people have about IRAs to help you decide whether it’s a good retirement investment vehicle for you.
1. How is an IRA different from a 401(k)?
Both IRAs and 401(k)s are tax-advantaged ways to grow money for retirement, but whereas a 401(k) is an employer-sponsored plan that is offered through a person’s job, an IRA is an account you can open on your own.
Benefits of 401(k)
On the one hand, a 401(k) can be beneficial to people who want to “set it and forget it”—and have money deducted automatically from their paycheck into their retirement account, without worrying about making payments.
Additionally, the maximum allowed yearly contributions to a 401(k) are larger than that of an IRA. For 2021, employees can contribute up to $19,500 to their 401(k), with an additional $6,500 in catch-up contributions if they’re over age 50. Employers can also contribute “matching” funds to your account, for a total of $58,000 (or $64,500 including catch-up contributions) per year.
Benefits of an IRA
For people who may have money that’s currently sitting in a checking, savings, or investment account, an IRA might be a good place for it to grow and help prepare you for your future.
An IRA can also be good for people who are not offered a 401(k) plan through their employer. IRA contribution limits are less—$6,000 per year as of 2021, with an additional $1000 in catch-up contributions for people over age 50.
The bottom line, however, is that you don’t need to choose between these two different retirement plans. If you have access to an employer-sponsored 401(k), it’s often a good idea to contribute as much as possible, then supplement with an IRA if desired.
Recommended: How to save for retirement if you don’t have an employer-sponsored 401(k)
2. Traditional vs. Roth: How do they work?
The two most common types of IRAs are traditional and Roth. (There are other kinds, like SEP and SIMPLE IRAs, but those are geared toward people who are self-employed or running small businesses. If that applies to you, read more about SEP IRAs.)
The biggest difference in a traditional vs. Roth IRA is when your money is taxed. With a traditional IRA, you get a tax deduction when you contribute money—so the money going into your account is tax free, and when you withdraw it in retirement, it will be taxed.
With a Roth IRA, you don’t get a tax deduction when you contribute but your money grows tax-free—meaning that when you withdraw it in retirement, you won’t pay taxes on the withdrawals. While that may be appealing to some people, it’s worth noting that Roth IRAs have restrictions around income when it comes to opening an account. In 2021 individuals must make below $125,000 (people earning more than $125,000 but less than $140,000 can contribute a reduced amount); for married people who file taxes jointly, the limit is $198,000 (or up to $208,000 to contribute a reduced amount).
Recommended: Rolling over your 401(k) is a pain—here’s why it’s still worth doing
3. Which IRA type is best for me?
While everyone’s situation is different, and only you can determine which kind of IRA is best for you, there are a few things to consider. If you have money sitting in a 401(k) from an old job, you might choose to roll that money over into an IRA (some employers will also let you roll over an old 401(k) into your current plan). Even if your employer previously paid the 401(k) fees, many stop doing that and pass them on to you when you leave. Plus, companies can merge or go out of business, and if that happens it may be more difficult to roll over your money.
Since the contribution limits are the same for both a traditional and Roth IRA, neither offers an advantage in that regard. So if you do qualify for both, one way to figure out whether a traditional or a Roth IRA is best for you is to think about your current tax bracket and what tax bracket you’re likely to be in when you retire.
If you don’t expect to earn any passive income in retirement (for example, from investments or rental income) and will thus be in a low tax bracket, you may want to take the tax deduction today and open a traditional IRA. If, on the other hand, you’re currently in a low tax bracket and expect to make more during retirement, you might opt for a Roth IRA.
Recommended: Traditional IRA or Roth IRA: Which one works for you?
4. How much should I put into an IRA?
Your goal generally should be to try to hit that maximum of $6,000 per year—or as close to that as your budget will allow. The important part is to make contributing a habit, and let the power of compound interest take over.
5. When should I make IRA contributions?
One simple way to fund your IRA is to set up an automatic contribution once a month that takes money from your checking or savings account and puts it directly into your IRA. Then, you never have to worry about forgetting to contribute, and you won’t miss (or spend) money that you never see. Use our IRA calculator to help determine which contributions you can make.
You don’t have to contribute monthly—the frequency is totally up to you, and many people contribute once annually, after they receive a year-end bonus, for example, or before the annual deadline of when taxes are due in April of the following year. (For tax year 2020, however, the deadline for contributions and filing has been extended to May 17, 2021.)
But consider this: the sooner you put money into the IRA, the more time it has in the market. Of course, investing isn’t without risk, but more time in the market means more time to (hopefully) grow.
6. Does everyone benefit from an IRA?
There are some potential drawbacks of an IRA for high earners. Here’s what to consider for each type of plan.
Anyone earning an income can open a traditional IRA and contribute to it, but in some cases, traditional IRA contributions may not be considered tax-deductible. For instance, if you’re single and you’re covered by a workplace retirement plan like a 401(k), your traditional IRA tax deduction starts to become reduced when your modified adjusted gross income (MAGI)—your gross income minus what you put into your 401(k) and medical premiums—is $66,000 for 2021.
For married couples filing jointly, where the spouse who makes the traditional IRA contribution is covered by a workplace retirement plan, the deduction starts to go away when that person’s MAGI is $105,000. For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction starts to phase out if the couple’s MAGI is $198,000.
As mentioned above, you can open a Roth IRA and contribute the maximum to it only if your income is below a certain level. For individuals who make more than $140,000 and married people who file taxes jointly and make more than $208,000, the Roth IRA is not an option.
If you fall into one of these categories, what should you do? If you or your spouse has a 401(k), one option is to start by maxing out that contribution each year.
7. How do I open an IRA?
An IRA can be an important part of an individual’s retirement investment strategy. Between traditional IRAs and Roth IRAs, it’s likely that you will find a plan that works with your timeline and goals.
Like so much else these days, opening an IRA can be done online. Though all the IRA rules are complicated, the process of opening one up with SoFi Invest® takes just a few minutes.Find out how to get started with your retirement planning, with SoFi Invest.
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