Individual retirement arrangements, or IRAs, are actively used by only about one-fifth of Americans. While many people have valid reasons for not using an IRA, like having a 401(k) at work, one of the most common reasons given for not contributing to an IRA is a lack of knowledge about this type of account. With that in mind, here are the answers to 10 of the most frequently asked IRA questions to boost your understanding about this excellent retirement saving vehicle.
1. What can I invest in with my IRA?
The short answer is "a lot." In an IRA, you can invest in virtually any stock, bond, ETF, or mutual fund you'd like.The better question is what should you invest in. While there's no one-size-fits-all answer, all IRA investors should have a basic knowledge of asset allocation, which can tell you how much of your money should be invested in stocks or stock-based funds, and how much should be in bonds and other assets.
2. How much can I contribute to my IRA?
For both the 2016 and 2017 tax years, you can contribute up to $5,500 per year to your traditional or Roth IRA. An additional catch-up contribution of $1,000 per year is allowed if you're over 50, for a total of $6,500.
It's important to mention that these limits apply to your total contributions, even if you have more than one IRA. In other words, if you have a traditional and Roth IRA, you can't contribute $5,500 to each one for 2017 -- your total contributions to both account must be under the limit.
3. Why contribute to an IRA instead of a standard brokerage account?
There are a few good reasons to contribute to an IRA. For starters, your IRA contributions and/or distributions may have tax benefits, as I'll discuss in the next section. Plus, your money will grow tax-deferred, meaning that you won't have to worry about capital gains or dividend taxes each year. In a nutshell, an IRA can allow your money to grow and compound faster than it otherwise would.
4. Will I get a tax deduction for my contributions?
It depends. Traditional IRA contributions may be tax-deductible, depending on your income and if you are eligible for a retirement plan at work. Roth contributions are not tax-deductible, but your qualified withdrawals will be 100% tax-free. Note that the ability to contribute directly to a Roth IRA depends on your income. You can find details on the income restrictions for both types of IRAs here.
In addition, low- to moderate-income taxpayers may also qualify for the Retirement Savings Contributions Credit, better known as the "Saver's Credit." This is a tax credit worth up to 50% of your first $2,000 in retirement savings contributions each year to an IRA, 401(k), or other account types.
5. What's the difference between a traditional and Roth IRA?
The main difference between a traditional and Roth IRA is the tax treatment I mentioned in the previous section. Traditional IRAs are pre-tax accounts, which means that contributions are generally tax-deductible, but withdrawals in retirement are considered to be taxable income. Roth IRAs are after-tax accounts, which means that you pay tax on the money now in exchange for tax-free treatment in retirement.
In addition to this difference, there are some other key Roth IRA benefits you should know about. You can read a thorough discussion here, but just to name a couple of examples, Roth IRAs allow you to withdraw your original contributions whenever you want and don't have any minimum distribution requirements based on a certain age.
6. What is the deadline for IRA contributions?
For any given tax year, the IRA contribution deadline is the same as the tax return deadline. This is typically April 15, but can vary depending on which day of the week Tax Day falls on. For the 2016 tax year, this deadline is April 18, 2017.
This makes the traditional IRA tax break unique, in the sense that it is the only major tax deduction that you can take advantage of after the end of the calendar year.
7. Can I borrow money from my IRA?
The short answer is "not really." Unlike 401(k) plans and other employer-sponsored retirement accounts, there is no such thing as an IRA loan. In fact, the IRS even goes so far as to say, "If the owner of an IRA borrows from the IRS, the IRA is no longer an IRA."
Having said that, there is a short-term way to get around this rule. Specifically, the IRS allows you to withdraw money from your IRA if you redeposit it into a qualified retirement account within the next 60 days. Known as the rollover rule, this is designed to allow people to move money between retirement accounts easily, but can be used for short-term borrowing from your account.
Before you do this, there are a few things you should know, so be sure to read this article before you hit the "withdraw" button.
8. Can I contribute to an IRA even if I have a 401(k) at work?
Yes. You can still contribute to an IRA if you have a 401(k) at work. However, your traditional IRA contributions may not be deductible if you don't meet the IRS's income limitations as discussed in question four. The ability to contribute to a Roth IRA and take advantage of its long-term tax benefits is only limited by the Roth income limits, not your participation in an employer's retirement plan.
9. Under what circumstances could I use my IRA before retirement?
Generally, you need to be 59 1/2 years old or older to withdraw money from your IRA without facing a penalty. However, there are a few exceptions.
One of the most commonly used exceptions is the ability to withdraw up to $10,000 for a first-time home purchase. It doesn't necessarily need to be your home -- for example, you can use the money to help your child buy a home -- but you can only use this exemption once.
You can also withdraw any amount of money from your IRA without penalty to pay for qualified higher education expenses, which is why IRAs (Roths in particular) are often referred to as a good option for college savings.
In addition to these reasons, you can also withdraw from your IRA early if you become permanently and totally disabled, to pay health insurance premiums while unemployed, and if you're a qualified military reservist called to active duty.
10. What if I retire before age 59 1/2?
If you plan to retire before the IRA retirement age, there are a couple of ways you may be able to access your money early without paying a penalty.
First, if you contributed to a Roth IRA, your original contributions, but not any investment gains, can typically be withdrawn early without penalty. As an example, if you've contributed a total of $100,000 to a Roth IRA that is now worth $300,000, you can withdraw from your account as long as you leave the $200,000 of investment profits untouched.
Second, for any IRA, you can access your account early, regardless of your age, if you agree to withdraw the money in a series of "substantially equal payments" based on your IRS-defined life expectancy. Just be aware that you have to continue these distributions for five years or until you turn 59 1/2, whichever comes last, so this may end up draining your account faster than you'd like.