September 24, 2021

IRA Basics – Everything the IRS Wants You to Know

Are you new to retirement investing? Like everything that has to do with finances and the government, it can get complicated. The ideas are new, the account possibilities are seemingly endless, and there’s a ton of new terminology to learn. Don’t worry! By learning a few basic concepts and definitions, you’ll be able to speak intelligently about your retirement fund. Here is a basic primer as to what the IRS thinks you should know about IRAs and retirement plans.  

What is retirement investing? 

The U.S. government wants you to save for retirement. Financially it’s good for the country when its citizens can be self-sufficient. To encourage people to save for retirement, the government offers tax incentives. In short, if you’re willing to save money for retirement, the government will reward you with a tax break. (We’ll discuss the nature of the tax break a bit later on.) A retirement account - like an IRA – is the vehicle you use to invest and save for retirement.  

What is an IRA? 

Retirement accounts come in a variety of forms. The two most popular are the IRA – Individual Retirement Arrangement – and 401(k). Even within these two, there are many different kinds. Here we will focus on the iterations of the IRA. The basic IRA is a dedicated account set up with a qualified custodian. You make contributions into the IRA account from your income, the account grows via various investments, and you take withdrawals once you reach retirement age.  

An IRA, like most retirement accounts, comes in two basic variations: Traditional and Roth. 

  • Traditional IRA – A Traditional IRA is funded with contributions from pre-tax dollars. That means that the funds you put into your IRA haven’t had any taxes paid on them yet. The tax benefit in this kind of account come from the fact that whatever funds you contribute are not counted towards your income for the year. If you made $75,000 for the year and contributed $5,000 into your Traditional IRA, you would only have to pay taxes on $70,000 worth of income. Eventually you’ll pay taxes on those funds, (when you take them out as a withdrawal,) but at that time you should be able to save on your tax bill. This is because at the time of retirement you’ll probably be in a lower tax bracket, and therefore responsible for less taxes. 
  • Roth IRA - A Roth IRA is funded with post-tax dollars. In this kind of account, if you make $75,000 this year, you would pay taxes on the full amount. That means that when you then make a $5,000 contribution to the IRA, it’s being made with funds that have already been taxed. This sets up an amazing benefit for later. The IRS says that in return for paying taxes on your retirement account now, you’ll will never be taxed on those funds again. Even if your Roth IRA invests well and grows tremendously, the funds will remain tax free. 

Types of IRAs 

There are many different kinds of IRA accounts, and many of them come in both Traditional and Roth versions. Here are some of the more popular ones: 

  • Classic IRA - This is an IRA where all the contributions come directly from the account holder. If you approach a bank or brokerage to open an IRA, it will usually take this form. The institution will give you a few investment options (e.g. a choice of mutual funds) and you can direct your money accordingly. 
  • Payroll Deduction IRA – This is like a classic IRA, with the only difference being that contributions are automatically deducted from the employee’s paycheck. 
  • Self Directed IRA – This is an IRA account that enables users to invest in assets that go beyond the stock market. An investor makes standard contributions, but then use them to purchase assets like real estate or shares in a private business. 
  • SEP IRA – This is an IRA that is funded solely by the employer. It has economic set-up costs and high contribution rates. A SEP IRA is used as a cost-effective incentive by employers to offer retirement benefits. 
  • SIMPLE IRA – SIMPLE stands for Savings Incentive Match Plan for Employees. A SIMPLE IRA is similar to a company 401(k) but much easier and cheaper to set up. There are no filing requirements for the employer, and it allows for both employee and employer contributions. It’s meant to be utilized by small businesses, i.e. those with 100 employees or less. 

Who offers IRA accounts? 

IRAs are offered by a variety of financial institutions. The most popular IRAs are those offered by big brokerages and mutual funds. These have the advantage of being streamlined, easy to open, and very hands-off for the account holder. The only downside is that you will be limited in terms of asset choice. Brokerage IRAs focus almost exclusively on market products like stocks and mutual funds. For most people, this exclusivity is not a deciding factor. The stock market has historically been productive over the long term, and account holders themselves often don’t have the wherewithal to go at it on their own. For these kinds of investors, staying in a brokerage IRA or company 401(k) is the best bet. 

However, there are good reasons to consider alternatives. Historical precedent doesn’t always accurately predict the future. (This is a much repeated statement in terms of the earnings of various IRA offerings.) If an investor wanted to truly diversify, they could put some funds in a classic brokerage IRA, while at the same time direct other funds to a Self Directed IRA. This would allow them to get the benefits of both asset classes. A popular asset choice for a Self Directed IRA is a conservative rental property. The allows the account holder to grow their IRA funds both by rental income, as well as property appreciation. This is also a good hedge in case the stock market takes a tumble. 

To open a Self Directed IRA, you have to go to a custodian who specializes in this kind of IRA. These custodians are optimized to accept alternative IRA assets like property and private placements. To find out more about self direction, schedule a call with a Madison specialist. 

IRA Contribution Limits 

The IRS has strict contribution limits to IRA accounts. However, there is a lot of variability depending on age, personal situation, and the kind of accounts that you will be contributing to. Here are the basics: 

  • Current (2022) IRA contribution limits are $6,000 per account holder. That goes up to $7,000 if the account holder is 50 or older. 
  • There are no IRA contribution limits for rollovers.  
  • Roth IRAs have a more complicated contribution schedule. Factors that influence the Roth IRA contribution include Modified Adjusted Gross Income (MAGI), whether the account holder is married, and whether the account holder or their spouse have other retirement accounts that they make contributions to.  
  • Since 2020, there have been no age restrictions on making an IRA contribution if the individual has proof of earned income. 

IRA Rollovers 

An IRA rollover occurs when an account holder would like to rollover funds in an existing retirement plan to a new IRA. This could be done for a number of reasons including leaving a company which offered a 401(k) plan or opening a self directed IRA to take advantage of alternative assets. Many rollovers can be performed directly, i.e. moving from one retirement account to another, but sometimes that is not possible. In those cases, the account holder has 60 days to place the funds in a new IRA account without suffering any penalties. One further rule to keep in mind is that for any given IRA, you can only make one rollover per year from it. This rule has a lot of details and you can read more about it here

IRA Distributions 

When you take out money from your IRA, it is called a distribution. IRA distributions break down into two basic categories: voluntary and required. A required distribution – also known as a RMD (Required Minimum Distribution) - starts when the IRA account holder turns 72. The amount of the distribution is determined by a number of factors including the size of the IRA account and presence of other retirement accounts. When this distribution is taken, taxes will be due on the withdrawn amount. In the case of a Roth IRA, no taxes are due as they were already prepaid at the time of the contribution. In a voluntary distribution, taxes are also due, as well as any penalties that may apply to an early withdrawal. 

Got Questions?

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