No matter your age, it's never too early to start saving for retirement. But in order to amass a sizable nest egg, you'll need to invest your savings to help that money grow. That's where an IRA comes in handy. IRA stands for "individual retirement account," and it's a personal savings plan for individuals that lets you choose your investments to grow your wealth. There are different account types to choose from, such as a traditional IRA or a Roth IRA, and each has its own benefits.
How IRAs work
Unlike 401(k) plans, which are employer-sponsored, IRAs are established at the individual level. As long as you have taxable income, you can open an IRA through your bank or brokerage firm. The amount you put in, however, is subject to annual contribution limits established by the IRS. For 2016, the limit is $5,500 a year for those under age 50 and $6,500 a year for anyone aged 50 and older.
Once you contribute money to an IRA, it's up to you to choose your investments, whether they're stocks, bonds, or mutual funds. As the owner of the account, you assume all of the risk related to your investments, but if they perform well, you stand a good chance of growing your balance over time. Just as importantly, any money you invest in an IRA can grow on a tax-deferred basis for as long as it's in that account. Having your investments sheltered from capital-gains and dividend taxes could save you large sums of money over the course of decades.
You can start making penalty-free withdrawals from an IRA as early as age 59-1/2. Though there are some exceptions, if you withdraw money before you reach 59-1/2, you could face a 10% early-withdrawal penalty.
Traditional versus Roth IRAs
There are different types of IRAs. The most popular choices are the traditional IRA and the Roth IRA. The primary difference between the two involves when you pay taxes on the money you contribute. With a traditional IRA, the money you contribute goes in before tax, lowering your taxable income in the current tax year. Then, when the time comes to take money out in retirement, your withdrawals are taxed as ordinary income. Roth IRAs work the opposite way: You don't get a tax break on your contributions up front, but the withdrawals you take in retirement are tax-free.
Roth IRAs offer a few additional benefits that traditional IRAs don't. With a Roth IRA, you can take out your money at any time -- even before age 59-1/2 -- without incurring a penalty, so long as that withdrawal is limited to the amount of your principal contributions, and not your investment gains. Furthermore, whereas traditional IRAs require that you start taking minimum distributions once you reach age 70-1/2, Roth IRAs don't have this restriction. This means that if you have money in a Roth IRA and don't need it right away in retirement, then you can keep it fully invested so it grows even more.
The downside to Roth IRAs is that not everyone is eligible. As of 2016, if you earn $132,000 or more as a single tax filer, or $194,000 or more as a couple filing jointly, you're ineligible for the Roth option. That said, anyone can contribute money to a traditional IRA and then roll those funds over to a Roth IRA, though they'll have to pay taxes on the money they roll over. This is known as a "backdoor" Roth IRA contribution.
If you're self-employed or own a small business, another option to consider is the SEP IRA. SEP IRAs are similar to traditional IRAs in that the money you contribute goes in pre-tax, and withdrawals are taxed in retirement. The difference, however, is that SEP IRAs come with a higher contribution limit. For 2016, you can put up to $53,000 or 25% of your income into a SEP IRA -- whichever is less.
Employers who have 100 or fewer employees can set up a SIMPLE IRA. If your employer offers this option, then as of 2016, you can contribute up to $12,500 in pre-tax dollars if you're under age 50, or $15,500 if you're 50 or older. Your employer is also required to make annual contributions to the plan (even if you choose not to participate), either in the form of a flat 2% of your compensation or in matching contributions that don't exceed 3% of your pay.
An IRA can be a valuable tool for helping you save for retirement, so it pays to learn more about the options available. The sooner you begin putting money aside for the future, the more opportunity you'll have for that money to grow.
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