What is an IRA?

When I graduated from college, my dad sat me down and explained that he wanted to help me open up a Roth IRA.

A what-now?

This did not sound like fun.

I figured anything that is named by a bunch of letters is usually complicated and when it comes to money, complicated is scary.

scared boy meets world

Basically me when I first heard the words “IRA”

As he explained what it was and how it worked, though, I started getting a little excited. And when I did my own research, I got a lot excited. Turns out, IRAs, particularly Roth IRAs, are pretty darn cool.

If you’re nervous about finances the way I used to be, it may sound crazy-pants to get excited by something that sounds both boring and confusing.

Fear not. I’m going to walk you through the important basics of IRAs and before you know it, you’ll be able to throw the term “IRA” around like you’ve always known what it means. You MIGHT even get a little excited.

Let’s get started.

What does IRA stand for?

IRA stands for “Individual Retirement Arrangement” although many people just say “Individual Retirement Account” because it makes more sense that way.

What is an IRA?

It’s a retirement account. This means it’s designed for you to put money in it, then invest that money in stocks and bonds, then sell those and take your money out gradually when you retire. Money in your retirement accounts is the money you will live off when you aren’t earning an income anymore.

Where can I open one?

You can open an IRA for yourself without going through an employer. Most brokerage firms, like Vanguard, Fidelity, Charles Schwab, and even E*Trade offer IRAs.

Who can open an IRA?

Anyone, including children, can open and put money into an IRA as long as they earn money somehow. It doesn’t matter whether you have a full-time job or if you babysit or shovel snow as a side gig, you can open an IRA as long as you earned some money and are reporting it to the government. No earned money? No IRA.

Parents can contribute to their child’s IRA as long as the contribution isn’t more than the child earned that year.

How many types of IRA exist?

There are four types of IRA, but we’re going to focus on the main two today: Traditional and Roth IRAs.

The Traditional IRA

The OG IRA.

You can put money into a Traditional IRA before you pay income taxes on it, so you avoid paying taxes on that money right now.

Instead, you pay the taxes when you withdraw the money in retirement. Anything you take out once you reach age 59½ will be taxed like income.

Taking anything out of the IRA before that time will cost you a 10% penalty.

The maximum amount you can put into this account per year (your “contribution“) is $5,500.

**UPDATE: Starting in 2019, the new max is $6,000!

Traditional IRAs are great for when you’re making a really nice salary and are getting closer to retirement.

The Roth IRA

Roth IRAs are the best for young or lower-income people.

Roths allow you to put money into them after you’ve already paid the income tax on it, which means you pay taxes now.

However, all the money you pull out after age 59½ is tax-free, INCLUDING any money you make by investing what you put in (money you make with investments is called “gains“). Income that’s tax-free?! Yes, please.

If you need to, you can take out the money you put into a Roth IRA for free at any time. You CANNOT take out your gains before age 59½ without paying the 10% penalty, but at least you have access to some of the money in the account without having to pay extra. Not that you should ever take money from your retirement account before retirement, but it’s nice to know it’s there.

The maximum amount you can put into this account per year is $5,500.

**UPDATE: Starting in 2019, the new max is $6,000!

Roth IRAs are great for when you aren’t making a ton of money because you pay smaller income taxes now and avoid paying taxes later.

PSST…if this is all a lot to take in, here’s a printable that lists these differences:

The ABCs of IRAs Printable

Which is better?

If you start your IRA early, the chances are good that you will make significant gains on that money, so a Roth is the better choice. Paying taxes on your lower income now will allow you to pull out a nice income during retirement without paying a dime of taxes on it.

As you get closer to retirement, Traditional IRAs often become the better option. The more money you make, the higher your taxes are. Most of us will make more as time goes on, and Traditional IRAs let you avoid paying heavy taxes on some of your income when you’re earning the most.

When you retire, as long as you pull less money out of your account than you used to make, you will pay less in tax than you would have using a Roth.

Confusing? Let’s look at some numbers.

Warning- Math Ahead

Let’s say you make $35,000 at the age of 20.

Using a Traditional IRA

In 2017, you would be expected to pay $4,784 in income tax. That’s not a fun number, so what if you contributed $5,000 of your salary to a Traditional IRA? Your income would now be taxed as if it were $30,000 instead.

That lowers your tax bill to $4,034, saving $750! Nice. If that $5,000 grows at about 5% for the next 30 years, even if you never add anything else to the account, you’d have $21,610 when you were 60 years old.

You could then pull out that money, but you’d have to pay $2,775 in tax when you pulled it out (assuming the tax rates are the same in thirty years!). That brings your total tax paid to about $6,809.

Using a Roth IRA

But let’s say you pay that $4,784 of income tax and then put $5,000 into a Roth IRA. You would make that same $21,610, but wouldn’t have to pay any tax on it when you used it at age 60, so you’d end up paying $2,025 less than you would by using a Traditional IRA.

If you contributed regularly to your IRA, you’d see this play out with much bigger, sexier numbers, but the basic idea is the same. As long as you can, you should contribute to a Roth IRA.

What’s the catch?

These IRA things are starting to sound pretty awesome, right? But, of course, there are some rules that limit how much we can take advantage of that awesomeness.

First, you can only contribute $5,500 per year to your IRAs, total. So, if you have both a Traditional and a Roth IRA, you can put part of that amount, say $2,500, into one, and the rest, $3,000, into the other, but you can’t contribute more than $5,500 between the two.

Also, Roth IRAs have income limits. This means if you make more than $118,000 as an individual, you aren’t allowed to contribute the full $5,500 to a Roth IRA until your income drops below that number again. Once you make more that $133,000, you aren’t allowed to contribute to it at all. Similar rules apply if you are married. For a chart that helps clarify what the income limits are for a Roth, check out Fidelity’s chart.

There are no income limits for a Traditional IRA, though, so if you are lucky enough to be making too much to put money in a Roth, contribute to a Traditional IRA instead.

Lastly, the early-withdrawal penalty I mentioned above can be painful if, for some reason, you HAVE to take money out of an IRA. All the more reason to set up an emergency fund.

Wrap-Up

The Benefits of IRAs

An IRA is a great way to stash away extra money for retirement. If you are already contributing to a work retirement account or if you don’t have an account through work, an IRA can help you stay on track to afford retirement.

Also, the fact that anyone earning income can contribute to an IRA means you can get a jump start on saving before you’re even in a full-time job.

The Potential Pitfalls

Like most retirement-specific accounts, IRAs have rules that punish you if you take money out too early. That doesn’t mean you CAN’T get to that money if you absolutely need it, but you may pay a 10% penalty for taking it out early.

There are exceptions to these rules, especially with a Roth, which is yet another point in its favor, but try to think of money in an IRA as off-limits.

And now you know the basics of an IRA! Congrats on making it through. As a reward, here’s a puppy in a cup!

chihuahua-dog-puppy-cute-39317.jpeg

Now, go open yourself a Roth and start stashing those extra dollars!

 

Disclaimer: None of the companies, apps, or websites mentioned in this article paid me to mention them.

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