If you aren’t familiar with what an IRA is, it’s a tax-advantaged account people use to invest for retirement and grow their wealth. “IRA” stands for “individual retirement account,” and you can find this type of account available at many different financial institutions. Although IRAs carry many of the same tax benefits that a 401(k) might, you don’t need an employer to open your IRA.
IRAs can come in a few different variations, such as traditional, Roth, and Heritage. Each variation has its own unique qualities that may make it a better option for one investor over another. In this article, we’ll talk about these variations along with other topics such as, how IRAs work, their tax planning benefits, and when you should create one.
If you have a question about IRAs in your unique situation or want to learn more about how to use IRA tax advantages, don’t hesitate to reach out to Damiens Law Firm, PLLC for assistance.
What is an IRA & how does it work?
As we mentioned above, an IRA is an investment account people use to ensure they have the financial assets they’ll need to live off of during retirement. When you open an IRA, the tax-deferred or tax-free contributions you make to the account can be invested in stocks, bonds, CDs, and other investment assets.
Unlike a 401(k), you have more freedom to pick and choose the assets you want to invest in if you feel confident in making such decisions. If not, you can use an advisor to help you select your assets and diversify your portfolio. If you want to change your investments – like moving money from stocks to bonds – you can do that too without incurring capital gains taxes.
Types of IRAs you can use
There are two very common types of IRAs to choose from: traditional and Roth. Depending on the type of IRA you establish, your contributions can grow on a tax-deferred or tax-free basis. If you’re having trouble deciding between a traditional and Roth IRA, your decision may come down to a preference for taking advantage of tax advantages now versus later in life.
A traditional IRA is a tax-deferred retirement savings account. Contributions to a traditional IRA aren’t taxed and there is no tax on any additional value your portfolio gains through investing. With a traditional IRA, you only pay taxes when you make distributions, which can help you lower your taxable income until you reach retirement.
Anyone can establish a traditional IRA, but until age 50, you can only contribute $6,000 per year. After age 50, this limit increases to $7,000 per year. Minimum distributions, which are taxable withdrawals, are required once you reach age 72. Early withdrawals (before age 59 ½) incur penalties.
A Roth IRA is a tax-free retirement savings account funded with taxed income. Unlike a traditional IRA, there is no tax owed on withdrawals during retirement – not even on any additional value your investment accrues over time.
Although anyone of any age can open a Roth IRA, certain income thresholds might apply: As of 2022, single tax filers must make less than $144,000 per year to contribute to a Roth IRA, and married couples filing jointly must have a combined income of less than $208,000.
The contribution limits are generally the same as a traditional IRA: up to $6,000 annually before age 50, then up to $7,000 at age 50 and after.
Another important distinction is that a Roth IRA doesn’t come with minimum distribution requirements. Because you already paid tax on your initial investment, qualified withdrawals are completely tax- and penalty-free.
Is an IRA a good investment?
When it comes down to it, an IRA is a good investment depending on whether its advantages are used. When these advantages are properly utilized, IRAs can be fantastic financial tools for preserving and building wealth for retirement. They can also be used before retirement to save on taxes, too!
The benefits of a traditional or Roth IRA are many, but here are a few:
- Traditional IRAs can reduce your taxable income by up to $6,000 before age 50 and up to $7,000 at 50 and after.
- Roth IRA distributions are tax-free because contributions are made with after-tax dollars.
- Both are easy to set up and there is no age threshold or limit to start. Also, IRAs of all kinds can be opened with many different financial institutions, which gives you choice when it comes to with whom you want to invest.
- Both allow you to manage your assets yourself or work with a financial professional to fine-tune your investment strategy.
- Both are completely yours, not someone else’s investment system that you participate in, like a 401(k).
When should I create an IRA?
When it comes to investing for retirement, the best time to start is right now. Whether you’re at your first job out of college, nearing retirement, or somewhere in between, starting now is the way to go if you don’t have an IRA.
Ideally, people begin saving for their retirement as soon as possible. For young professionals trying to make rent, this isn’t always possible. Those with children can also find it hard to start saving for retirement, but every dime counts for something. By investing what you can with an IRA now, you can set yourself up for success when you have more income to devote to your contributions.
Contact us for tax planning help
Your IRA can play an important role in your overall tax planning strategy. If you would like to learn more about how this is possible, reach out to Damiens Law Firm, PLLC to learn more about what we can do for you.