Should You Invest in an IRA? A Quick and Easy Guide to Understanding Individual Retirement Accounts.

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Published by GreenSprout Experts | 07-10-2022

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When it comes to saving for your retirement, there are many options on the table. One of the most frequently mentioned is the IRA, or individual retirement account. But what exactly is an IRA, and how does it work? Keep reading to learn all the details.

What Is an IRA?

To put it simply, an IRA is an investment account that offers tax advantages and helps you save for your retirement. IRAs are one of the most popular and frequently used methods for retirement saving, and one of them might just be perfect for you.

The reason IRAs are popular is because the contributions you make to them are usually tax deductible; this means you will save on your taxes at year end, as well as put away more for your retirement. On top of that, depending on the circumstances, your withdrawal from the IRA later on might be tax-free, which means more money in your pocket.

The money you contribute to your IRA will grow over time. How fast it grows will depend on the choices you make to allocate your investment. You have the option of investing your IRA in stocks, bonds, or other assets, as well as the ability to change the investments later on if you feel the need. You can check the status of your investment and see the earnings reports and other figures to help you make decisions on how to allocate it.

One of the main reasons why people choose an IRA instead of (or in addition to) a 401(k) is that an IRA offers more flexibility in the type of investments it has available, as well as potentially greater returns.

Which IRA Is Right for Me?

Starting an IRA is as easy as visiting your bank, broker, or financial advisor. Once your IRA is set up, you can start contributing funds to it and select how those funds will be invested.

There are currently 4 popular types of IRAs, so let's take a minute to explain each of them so that you can decide which one is best for you.

Traditional IRA

The traditional IRA offers tax-deductible contributions (up to a set limit), which helps you save on taxes at the end of each year. However, this contribution amount is dependent on other circumstances. For instance, if you or your spouse already has a retirement plan from your employer, the amount you can deduct could be reduced or even voided if your income exceeds the limit (see IRS guidelines for more details). Don't worry, you can still make contributions to your IRA; they just won't be tax-deductible.

For 2021 and 2022, the contribution limit is $6,000 annually for those aged 49 and under, and $7,000 for those aged 50+.

When it's time to make withdrawals from your traditional IRA, they will be taxable just like any other form of income.

Roth IRA

The Roth IRA is the opposite of the traditional in that your contributions are not tax-deductible; however, the withdrawals you make later on are tax-free. In addition, there is no tax placed on the gains from your investments. This makes the Roth IRA the preferred choice for investors who have a long way to go before retirement, based on the assumption that the tax they pay now on their contributions will be lower than what they would end up paying later on their withdrawals.

Much like a traditional IRA, the limits are the same for single filers, with an annual contribution of $6,000 ($7,000 for those aged 50+) as long as your adjusted gross income is below $140,000. If the person is married, that limit rises to $208,000.

SIMPLE IRA

The acronym SIMPLE stands for Savings Incentive Match Plan for Employees. The SIMPLE IRA is designed for businesses with 100 employees or less.

With a SIMPLE IRA, the employer must also contribute to the IRA. Just like in a traditional IRA, the contributions are tax-deductible, and later on, the withdrawals are taxed as income. The big difference is the amount that you can contribute; for 2022, this amount is $14,000 annually for those 49 and under and $17,000 for those 50 and over.

SEP IRA

If you are self-employed or only have a handful of employees, then the SEP IRA might be right for you. The tax status of contributions and withdrawals follows the same as that of the traditional IRA.

However, the limits for a SEP IRA are calculated in a different manner. For 2022, this limit is 25% of your annual compensation, or up to $61,000 whichever is lower. There is no difference based on age, and you must start taking your minimum withdrawals at age 72. If the business owner contributes to the SEP IRA for themselves, they must also contribute a proportional amount to each eligible employee.

Should I Have an IRA or a 401(k)?

Why not both? Yes, that's right you can have both an IRA and a 401(k).

Generally, a 401(k) includes an employer match up to a certain amount; then, you can invest in an IRA of your choice to further increase your retirement savings.

IRAs usually offer more flexibility in terms of choice of investments, whereas choices with an employer-sponsored 401(k) might be limited.

Since each person's situation will differ based on what is offered by their employer, it is up to you to evaluate your options and choose what would be best for you.

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