An Individual Retirement Arrangement - popularly known as an IRA - is an important retirement savings vehicle, especially for people who are not covered by a retirement plan at work. Knowing the different kinds of IRAs and how they work can put you on a path toward a more comfortable retirement.
The following is a comprehensive guide to what you need to know about IRAs.
What is an IRA Account?
An IRA is a type of retirement plan that allows you to defer certain tax obligations until you start drawing money out of the plan upon retirement. The advantages of this are that you can allow money to grow tax-free, and in many cases you can manage your eventual withdrawals from the plan so they come at a time when you are in a lower tax bracket.
Types of IRA Account
Traditional IRA Account
The two major types of IRA are traditional IRA and Roth IRAs. The key difference is that with a traditional IRA, you can deduct your contributions to the plan, and defer paying taxes until you start to draw money out of the plan.
Roth IRA Account
With a Roth IRA, you don't get an initial deduction for your contributions, but then qualified distributions taken out of the plan later on are tax-free. This means a key factor in choosing between a Roth and a traditional IRA is whether you feel you are in a lower tax bracket now than you expect to be in retirement, since the choice affects whether you pay taxes on your IRA contributions now or in retirement.
An IRA differs from an employee-sponsored retirement plan like a 401(k) in that it is an individual plan in your name, rather than a collective plan covering a group of employees. This gives you greater control over how the plan is managed.
Traditional or Roth IRA Account?
The following chart summarizes some of the key distinctions between traditional and Roth IRAs:
When can you contribute?
Up until age 70 ½, as long as you have taxable compensation
At any age when you have taxable compensation, though income limits apply
How much can you contribute?
$5,500 per year, or $6,500 if you are aged 50 or older
$5,500 per year, or $6,500 if you are aged 50 or older
Are contributions tax-deductible?
Yes, though the deduction may be limited for high earners if you or your spouse are covered by a retirement plan at work
Are investment earnings taxable from year to year?
When can you withdraw money without penalty?
Age 59 ½
Age 59 ½, but withdrawals also must be at least five years after the IRA was established
Are qualifying withdrawals taxable?
Are there required minimum distributions?
Yes, you are required to start taking distributions once you reach age 70 ½
No, as long as you are the original owner of the IRA
Key selection factors:
Given the differences between Roth and traditional IRAs, here are some factors in deciding which is best for you:
- Current tax status. If you are in a high tax bracket, you are likely to benefit most from a traditional IRA that lets you take the tax deduction now. You will have to pay tax on withdrawals later on, but you may be in a lower tax bracket once you retire. If you are currently in a low tax bracket, a Roth might be best because it will allow you to avoid paying tax on withdrawals later on, when you may be in a higher bracket.
- Age. For the tax reasons explained above, Roth IRAs are often recommended for younger adults on the assumption that they are likely to be in lower tax brackets early in their careers. Roth IRAs can also make the most sense for workers at or close to retirement age who still consider it worthwhile to make long-term retirement investments.
- Retirement funding. If your retirement funding looks like it will be ample enough that you wouldn't spend all of the required distributions from a traditional IRA, you might do better with a Roth IRA so more of your money could continue to benefit from tax-free growth in your retirement years.
SEP IRA Account
While most IRAs are set up and funded solely by individuals rather than their employers, there are certain hybrid IRA-based plans that small employers can use to make IRA contributions on behalf of their employees. Simplified Employee Pension (SEP) plans are one of the two major IRA-based employee benefit plans. Individual IRA plans are set up for each eligible employee. In a SEP IRA, the employer then makes annual contributions to those plans.
SIMPLE IRA Account
Savings Incentive Match Plans for Employees (SIMPLE) is the other most common IRA-based employee benefit plan. With a SIMPLE plan, the employer matches each employee's contributions, subject to plan limits, to those plans.
IRA contribution limits
Because there is a tax advantage to putting money into an IRA, the Internal Revenue Service limits how much you can contribute each year. This amount is adjusted from time to time to account for inflation.
Contribution limit for traditional and Roth IRAs in 2017
For 2017, the general contribution limit for Roth and traditional IRAs was $5,500 per year. You can make a contribution for a given tax year up until the tax filing deadline for that year, typically on or around the following April 15. See the table below for 2018 contribution limits for 401(k)s and IRAs.
There are some exceptions to the general contribution limits. If you are aged 50 or older, you can make larger contributions, sometimes known as "catch-up" contributions. For the 2017 tax year, the limit for people aged 50 or older is $6,500, or $1,000 more than the general limit.
In any case, you cannot contribute more than you earned in the same tax year. Also, Roth IRA contributions are subject to limits based on tax filing status and income.
Finally, once you reach age 70 1/2, you can no longer make contributions to a traditional IRA, though you can continue to make contributions to a Roth IRA for as long as you live.
Table of contribution limits for 2018
The following table shows the current limits for several popular types of retirement savings, including 401(k)s.
Type of Retirement Savings
2018 Contribution Limit
Contributions are made by employers only
Catch-up contributions (additional amounts available to people aged 50 or older)
$1,000 for IRAs
Examples of retirement savers based on contributions
How important is it for you to max out your retirement savings by making the most of the above limits? Consider the following three examples.
Chrissie, Jimmy and Martin are three colleagues earning roughly the same pay and they discuss saving for retirement.
- Chrissie: The aggressive saver. Chrissie decides to save aggressively by contributing the $18,500 limit to their company 401(k)
- Jimmy: The procrastinating saver. Jimmy decides retirement saving can wait for a while and opts to wait for five years, after which he starts saving as aggressively as Chrissie
- Martin: The more laid back saver. Martin takes a different approach and starts saving right away, but at only half the contribution level as Chrissie
Retirement saving totals
- Chrissie: About $883,000. Twenty-five years later, with modest 5 percent annual returns, Chrissie's 401(k) balance has grown to $882,951.
- Jimmy: About $612,000. As for Jimmy, he eventually contributed the same annual amounts as Chrissie, but started five years later. At the end of the period, he would end up with a 401(k) balance of $611,720, meaning that because of lost contributions and investment growth, his five years of delay cost him $271,231.
- Martin: About $441,000. As you might expect, Martin's balance is half as much as Chrissie's - he started saving as early as Chrissie, but with only half as much an annual contribution. What might be surprising is that in 25 years, an annual difference of $9,500 in contributions could grow to a gap of over $440,000 in the 401(k) balance.
These are extreme examples, but they illustrate how differences in the timing or amount of retirement savings get magnified over time by compounding, and can result in very meaningful differences in retirement lifestyles.
To calculate your own projected retirement fund total, use a retirement savings calculator and input the amount of your annual contributions, estimated rate of return and more.
How to max out retirement contributions
There are several ways to save for retirement, and all of them are worthwhile. However, some approaches are better than others, and doing what you can to maximize your retirement contributions will make a big difference in how big a nest egg you build up by the end of your career.
Here are eight tips that will help you max out your retirement contributions:
1. Start early
Every year of delay costs you in two ways. There are limits to how much you can save for retirement each year, so you can't totally make up for lost years. Also, the sooner you start saving, the longer your savings will have to grow through compounding returns. Start small if you have to, but start saving for retirement as soon as possible.
2. Be sure to earn your employer match
Certain employer-sponsored plans will match a portion of your contributions to those plans, but this is typically a use-it-or-lose-it type of deal. If you don't make the contribution, you don't get the match. Obtaining that match means getting extra compensation from your employer, so why leave that money on the table? Your first goal in retirement saving should be to contribute enough to get the full employer match available.
3. Don't settle for default deferral amounts
Some employers try to encourage employees to save for retirement by having an amount of your paycheck automatically contributed to a retirement plan unless you opt out. This is helpful, but these default deferrals will usually represent a minimum amount of retirement savings. Don't assume this amount will be enough to build you a sufficient nest egg, and there is usually more room for you to earn tax-advantaged investment returns by contributing beyond the minimum.
4. Augment your employer plan with an IRA
In many cases you can get extra tax-deferred savings by contributing to an IRA in addition to your employer's retirement plan. Just be advised that there are income limits that might restrict or prohibit your ability to do this. Those restrictions vary depending on the type of IRA (traditional or Roth IRA) and the level of your income, so if you are a high earner, make sure you know what these restrictions are.
5. Know the legal limits
The table at the start of the next section shows how much you can contribute in various forms of retirement savings. Know how these limits apply to you so you can make the most of them.
6. Use catch-up contributions
If you are aged 50 or older you can often contribute additional amounts to your retirement savings.
7. Take advantage of the Saver's Credit
Most of the tax advantages of retirement plans is based on reducing the amount of your earnings that are considered taxable, but if you earn less than $31,500 (for single filers) or $63,000 (for married couples filing jointly), you may be eligible for an additional tax benefit. This is called the Saver's Credit, and can amount to as much as $2,000 for single filers and $4,000 for joint filers. A tax credit has even more impact than a deduction because it is a dollar-for-dollar offset against the tax you owe.
8. Don't neglect HSAs as wealth-building vehicles
While health savings accounts (HSAs) are often seen primarily as reserves that can be used for immediate health care expenses, you can accumulate savings in these plans year after year. Those savings will never be taxed as long as they are eventually used for legitimate medical expenses. Since health care costs represent a significant portion of most post-retirement budgets, HSAs offer an excellent means for augmenting your retirement savings.
How aggressively do I need to save for retirement?
So just how aggressive should a person get about retirement savings? It's best to draw the line before you are putting so much away for retirement that you can no longer meet your everyday expenses.
If expenses force you to backtrack and take money out of a retirement plan early, this will typically cost you a 10 percent penalty on top of any ordinary tax liability. If instead you rack up credit card debt to meet expenses while keeping up with your aggressive retirement plan savings, you are likely to pay more in credit card interest than you will earn on your savings.
In other words, saving too aggressively can end up costing you. The idea is to work out a budget that carves out room for retirement savings while leaving you enough money to meet your expenses. That approach balances your current and future needs, and should leave you better off in the long run.
How to invest in an IRA
Once the money is in an IRA, it needs to be invested. You have a choice of a wide range of investment vehicles for this. People often erroneously equate the IRA with the underlying investments in it, using phrases such as "IRA CD." The fact is the retirement vehicle and the underlying investments are two separate things. This means you have the flexibility to change investments within an IRA, as long as those investments are offered by your IRA custodian (the bank or brokerage firm holding the account).
Since this is a retirement vehicle, investments should be geared towards the length of time you have until retirement. For example, when you are young and have decades to go before retirement, the majority of your IRA investments should be long-term investments like stocks and long-term bonds. As you start to approach your retirement, your asset mix should start to incorporate more conservative investments like short or intermediate bonds and cash equivalents to provide stability and liquidity.
Where to find IRAs
IRAs are generally available from banks and brokerage firms alike, so you have literally thousands of choices for your IRA account. This breadth of choice makes it foolhardy to generalize about who the best IRA provider is because that decision depends largely on your needs and circumstances.
However, the following questions will help guide you toward finding the best IRA account for your situation. It will help you work through some of the fundamental decisions about what you need, and then identify some key selection factors according to those decisions.
In other words, the type of IRA you want and how you intend to invest it make a big difference in what you need from an IRA provider. Here are some of the questions you need to resolve in order to focus on the right selection factors:
Funding your IRA
You may be funding your IRA from one of three sources:
- Start-up contributions
- A transfer from an existing IRA
- A rollover from another type of retirement plan, such as a 401(k) (see section below on rollovers)
The source of your new IRA account matters for a couple of reasons. First, IRA contribution limits are just $5,500 a year (or $6,500 if you are aged 50 or older). So, if you are starting from scratch, your account value is going to be relatively small for a few years.
In contrast, if your account is being funded with assets from a transfer or rollover, your account will have more of a head start in terms of market value. In that case, an immediate concern will be what to do with the securities you held in the previous account.
How to choose an IRA account
Depending on the source of your funding, the following are some key selection factors in choosing your IRA provider:
Minimums and fees
- Minimum account size. If you are starting from scratch, you will want to find a provider with no minimum or a very low minimum, so your account will qualify at your first-year contribution level.
- Maintenance fees. These are periodic fees, typically monthly, charged just for having an account. If your account is a start-up or relatively small, it will be particularly sensitive to fees that are assessed as a set dollar amount rather than as a percentage of the account. Any given dollar amount will represent a higher portion of a smaller account, so if you are just getting started, try to find an account with no maintenance fees or at least fees that are charged as a percentage of the account's value rather than as a fixed dollar amount. If your account is being funded by an existing account that has built up a substantial market value, the opposite may apply - you may be better off paying a low fixed fee rather than a percentage of the account.
- Transfer fees. This isn't an issue if you are just starting out, but if you have an existing account with several securities in it, you should pay attention to transfer fees before choosing an IRA provider. Transfer fees are often charged per security, so bringing over a diversified portfolio of stocks and bonds might get expensive. In fact, before making a transfer from one account to another you should check both whether transfer fees are charged for moving securities out of your existing provider and whether they are charged for moving securities into your new account. If you can't avoid transfer fees, you may find it more cost-effective to liquidate your existing portfolio (though this does entail some transactions and possibly opportunity costs) before making the move.
Mutual funds or separate accounts
When it comes to investing your IRA, a fundamental choice is between mutual funds or separate accounts. Mutual funds pool your money with that of other investors, while a separate account consists of individual holdings in your name only.
Because pooling assets with those of other investors creates efficiencies of scale, funds are easier to diversify and are often more cost-effective, especially for smaller investors. Separate accounts allow for more customization, and might allow for the implementation of more complex investment strategies.
Key selection factors
Here are some things to think about when choosing between mutual funds or separate accounts for your portfolio:
- Portfolio size. It is difficult to efficiently diversify a portfolio below $100,000, and your choice of active managers might be quite limited unless you have at least $500,000 to $1,000,000. Figures from the Employee Benefit Research Institute (EBRI) show that average IRA assets exceed $100,000 only for age groups from the late 50s on, so younger investors should probably focus on mutual funds.
- Indexed or active management strategy. If you want an investment approach that seeks nothing more than to broadly represent the stock market, mutual funds are probably more efficient. For strategies that seek to actively add value over the performance of the stock market, an individually managed approach might be more versatile.
- Expense ratios. If you are using mutual funds, compare expense ratios before you choose. These ratios take into account both management fees and other expenses.
- Fees and commissions. For separately managed accounts, pay attention to both the annual management fee and the commissions paid on each security trade.
Stocks, bonds or cash?
Stocks provide more growth potential, while bonds are typically less risky and cash equivalents are safest of all but offer meager returns. EBRI figures show that IRA investors tend to be growth-oriented, with the majority of their portfolios in stocks even as they reach older age groups.
Key selection factors
Depending on which asset classes you intend to feature, your choice of an IRA provider should focus on different things. Chances are you will need a provider with competitive products in multiple asset classes.
- Market cycle performance. For stock-oriented investment products, the best way to evaluate performance is by looking at how the product has done over both rising and falling phases of a market cycle.
- Bond quality. Bonds are only safer than stocks if they are of investment-grade quality. Otherwise, you might be taking equity-level risk without the same return potential.
- Interest rates. While returns on savings accounts and other cash equivalents are pretty low, remember that IRA balances can grow quite large over time, so even small differences can add up to meaningful dollars.
- Safety. For cash-equivalents, there is nothing safer than an FDIC-insured deposit account, as long as your balance does not exceed the $250,000 insurance limit. If you are using a brokerage IRA account, look for a cash fund that invests exclusively in short-term, U.S. government securities.
Retirement may seem like a long way off, but that's all the more reason to make wise choices about setting up your IRA. Most likely you will have an IRA for decades to come, so getting your account started on the right foot is a financial move that can serve you well for a long time.
IRA rollovers and taxes
If you want to change your IRA provider, you can do so without tax consequences as long as you make sure to roll the account over to another qualified IRA account within 60 days. Similarly, you can roll money coming out of a qualified employee benefit plan without tax consequences as long as you deposit it in its entirety into an IRA within 60 days.
Withdrawal requirements for IRAs
If you want to take money out of an IRA to spend it, you must generally wait until you are aged 59 1/2 or else you will incur a 10 percent tax penalty in addition to income tax consequences. There are exceptions for things like educational expenses and to some extent, buying a house. Finally, if you have a traditional IRA, you are required to start taking money out (and paying the income tax on it) once you reach age 70 1/2.
An IRA is not something you set up once and forget about until it's time to retire. It is something that needs regular maintenance, from keeping up with contribution limits to adjusting investment holdings to meeting withdrawal requirements.
However, these are not difficult tasks, especially once you get used to them. With a little bit of attention year-in and year-out, you should find that your IRA will make your life much easier when it comes time to retire.
Leaving a job can mean dealing with several changes. One of the most important details to take care of is rolling over your 401(k) plan balance, including the option to roll over to an IRA. Doing this the right way can keep your retirement savings program on track with little disruption. Failing to take care of your 401(k) rollover can cost you money now and in the long run.
The following guide will walk through some of the basic issues you need to consider when rolling over your 401(k) balance.
What is a 401(k) rollover?
If you have been participating in your employer's 401(k) plan, any money you have been contributing to that plan has been deductible from your income for tax purposes. The only catch to this tax advantage is that if you take the money out before age 59 1/2, you will not only have to pay ordinary income taxes on it, you will also have to pay a 10 percent early-withdrawal penalty.
So what happens when you change jobs? Most likely, you will have to leave your former employer's 401(k) plan, but you can do this without the 10 percent penalty if you roll the money from that plan into another qualified retirement plan within a 60-day 401(k) rollover time limit. Options include rolling the money over into a retirement plan at a new employer, or into an IRA.
The best way to do this is to have the plan administrator at your old employer transfer the money directly into the new plan. However, if you receive a distribution from the old plan by check, you can still avoid a penalty by depositing the money into an IRA or retirement plan within 60 days, though there will be some complications as described below under "tax considerations."
Rolling over to another employee-sponsored plan
From a tax standpoint, rolling your 401(k) balance into a qualified retirement plan at a new employer is probably the simplest thing. This will allow you to avoid paying any tax or penalty on the 401(k) balance. If your new employer is a corporation, they may have a 401(k) plan for you to roll your balance into, but you can also roll into a 403(b) plan if you go to work for an educational or not-for-profit organization, or into a 457(b) plan if you go to work for the government.
A direct transfer to one of these employer-sponsored plans should save you from worrying about tax consequences, leaving you only to set up your new investment choices.
Rolling over a 401(k) into an IRA
If you are not able to roll your 401(k) over into an employer-sponsored plan, you still have the option of rolling it into an IRA. In this case, you will face the choice between a Roth and a traditional IRA.
Remember that the key difference between a Roth and a traditional IRA is that with a Roth IRA, you pay taxes on the income upfront, so you don't have to pay taxes when you draw money out of the plan in retirement. With a traditional IRA, you get to defer income contributed to the plan until retirement, when you will pay ordinary income tax on any distributions. This difference affects how 401(k) rollovers are treated, as described below.
Tax considerations for rollovers
- Rollover a 401(k) into an employer-sponsored plan/traditional IRA. If you transfer your 401(k) balance directly into another employer-sponsored plan or a traditional IRA, there will be no tax penalty and you will continue to defer taxes on that money until you start to draw it out in retirement.
- Rollover a 401(k) into a Roth IRA. If you transfer your 401(k) balance directly into a Roth IRA, you will avoid the 10 percent early-withdrawal penalty, but you will have to declare that balance as ordinary income and pay taxes on it. The reason is that contributions to a 401(k) are considered pre-tax, while a Roth IRA is treated as after-tax money. The difference between a Roth and a traditional IRA determines whether you pay taxes on the rollover now or in retirement, so the choice largely comes down to whether you expect to be in a higher or lower tax bracket when you retire than you are in now.
- Receive a check for 401(k) funds. The tax situation becomes more complicated if you receive a check for your 401(k) proceeds rather than transferring it directly into a qualified plan. In that case, you are likely to be subject to a 20 percent tax withholding. Furthermore, if you do not deposit the proceeds into a qualified plan within the 401(k) rollover time limit of 60 days, you will be subject to the 10 percent early withdrawal penalty if you are younger than 59 1/2, plus any ordinary income tax if it exceeds the 20 percent withholding.
Even if you avoid the penalty by depositing the money in a qualified plan within 60 days, you will still have to deal with the 20 percent that was withheld by contributing an equivalent amount out of your own pocket. You can recoup that money by declaring it as taxes paid on your next tax return, but that will leave you without use of that money in the meantime. Also, if you do not contribute enough to make up for that 20 percent withholding, that portion may be subject to the early withdrawal penalty.
Investment options for 401(k) rollover
Your 401(k) plan likely had a menu of options ranging from conservative to aggressive. In choosing new investment options, start with where on that spectrum your choices had been, but then consider whether or not your situation has changed. As they get closer to retirement, people generally get more conservative about their investments, but other changes to your financial situation might prompt you to get more aggressive.
If you are rolling your money into a new employer-sponsored plan, you will need to choose appropriate options off of that plan's investment menu. If you are rolling into an IRA, you should choose an IRA provider that has the type of investment options you need. Fortunately, there are a huge number of banks and brokerage firms offering IRAs, and among these firms, you will find just about every investment option imaginable. You should consider your investment needs before settling on an IRA provider so you can pick one that has the right sort of investment options for you.
In the end, rolling over a 401(k) balance comes down to two things: making sure your money transfers into a qualified retirement plan to avoid tax consequences, and making sure you reinvest in appropriate vehicles for your retirement goals. Accomplish those two things, and you will set your 401(k) rollover up to continue working toward funding your retirement.