You are comfortably settled and earning your living in the U.S. Now is the time to start thinking about building a nest egg so that you can enjoy your retirement years in peace.
So, where’s the sticking point? Taxes.
Paying traditional taxes on your retirement savings can mean that you eventually end up with a smaller corpus than you planned for. Fortunately, in the U.S., you can work around this issue with Individual Retirement Accounts, or IRAs.
Confused about how IRAs work and what their benefits are? Read on for a simple explanation of the basic features of this account.
What is an IRA?
An Individual Retirement Account is a financial instrument that allows you to defer paying taxes on your contributions. Essentially, you save on the total tax you pay in two steps:
- You can contribute pre-tax dollars to your IRA. These contributions can be from any income sources, like your salary, stock returns, cash, etc.
- You can deduct these IRA contributions from your gross income. This means that you pay a smaller total tax on your annual income.
What are the different types of IRAs?
IRAs can be broadly categorized into three types:
- Traditional IRA
- Roth IRA
- Rollover IRA
Each type of account has different features associated with it. We break down the basics for you here.
What is a traditional IRA?
The contributions you make to a traditional IRA can be deducted from your gross income. You also don’t have to pay taxes on the saved amount until the time you withdraw it—that is, when you retire.
This means that traditional IRAs lower your taxable annual income. The tax you pay on the actual corpus of the IRA is also deferred until withdrawal.
- You save money by reducing your taxable income and reducing the number of times you have to pay taxes.
- If you expect tax rates to go down in the future, then deferring the tax payment can make a big difference.
Contribution limit: $6,000. However, $7,000 for those above the age of 50.
Note: There are some age restrictions on the withdrawal clause of a traditional IRA. You need to be at least 59.5 years of age to make a withdrawal. Otherwise, you might have to pay a 10% penalty for it.
What is a Roth IRA?
Unlike in a traditional IRA, you cannot deduct your Roth IRA contributions from your gross income. This means that your contributions are taxed.
- The final amount you withdraw from a Roth IRA is tax-free, since you already paid taxes on it when you deposited it.
- You can withdraw the money from the account any time you want. There are no penalties or taxes on the withdrawal.
- If you expect tax rates to go up in the future, then it is advisable to avoid paying a lump sum tax on withdrawals.
- It is a useful tool for young people to plan for a tax-free retirement. This is because Roth IRAs do not have age caps on when you can start contributing.
- The total amount you can contribute to a Roth IRA depends on your modified adjusted gross income (MAGI). The higher your income, the smaller your contribution limit.
- The annual limit is $6,000 but it is $7,000 for those above the age of 50.
What is a Rollover IRA?
A Rollover IRA allows you to transfer your assets from an old employer-sponsored retirement plan to a traditional IRA. Under this, you can move your 401(k), 403(b), or profit-sharing assets to an IRA.
- You can hold these assets at a tax-deferred status until retirement.
- There is no contribution limit on the rollover amount. This means that you can hold a wide range of investments in your IRA, including ETFs, mutual funds, stocks, bonds, and more.
- The rollover transaction is non-taxable, as per the IRS.
How to open an IRA
Consider the following pointers before you choose to open an IRA:
- Are you a hands-on investor, or do you require help managing your assets?
- Do you want to operate the account through a bank or a broker?
- Are you in the eligibility criteria for the type of IRA you want to open?
For hands-on investors:
If you choose to manage your investments and assets yourself, you can open an online IRA account. Any brokerage platform will give you this option.
Look for brokers that offer benefits like low commissions, tax-free transactions, low account fees, etc.
If you require help in investing:
Go to an advisor or asset manager. You can also choose an auto-investor option. This is essentially a computerized system that picks low-cost funds for your portfolio. The system will recommend funds based on your investment preferences, timeline, and risk averseness. Auto-investment options are typically cheaper than a human asset manager.
Alternatively, you can go to your local bank and ask to open an IRA.
Opening an account
Nowadays, the whole process can quickly be done online. All you have to do is go to the broker’s webpage and select the IRA type you want. It will ask you to provide personal details like identification documents, bank details, and income proof.
Once these details are verified, you are good to go!
Transferring the funds
If you are rolling over assets from an existing retirement plan like a 401(k), you can ask your previous employer to transfer the amount into your new IRA.
If you transfer funds from a regular bank account, you will have to make regular contributions to the IRA. We suggest setting up an automatic transfer mandate so that you don’t have to do it every time personally.
Just make sure to stay under the maximum contribution limit for your income range (especially for a Roth IRA).
What to keep in mind while investing?
- Diversify your portfolio according to risk. Have a good balance of low-risk and high-risk funds at all times.
- Invest deliberately. Remember, your retirement is a long-term investment, so have a game plan in mind before making decisions.
- Minimize your transaction costs. Ensure that you are not losing any money on unnecessary commission fees, maintenance charges, or transaction fees while operating your IRA. Choose your broker wisely.
This is a basic overview of how IRAs work in the U.S. Of course, you will need to research carefully before investing your money in one.
Disclaimer: Just like any advice on the Internet, this is no replacement for CSE-specific financial advice that a consultant can offer. Use this information to research further, and vet your understanding by using the service of an advisor. Check your local library to see if they organize any financial management sessions from experts, which you can access for free.
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