Hi everyone, and welcome back to Melissa Making Cents!
As a CERTIFIED FINANCIAL PLANNER and financial coach, I know many of the stressors for people's finances. Especially for younger people, the subject of IRAs, retirement accounts, and the like are the cause of a lot of anxiety. Educating yourself and your loved ones about financial principles is the best way to avoid that anxiety and make sure there's never a lingering concept just out of reach of your understanding. The truth is - IRAs aren't too complicated for you or for anyone to understand. All it takes is putting in a little bit of legwork to broaden your understanding of the subject.
While retirement may seem like something that's way off in the distant future, that isn't the case. While you may not be close to retirement age presently, what's more, important is that you're taking the necessary steps to prepare yourself for when that age does come. Educating yourself, working with a financial advisor/financial planner, and regularly contributing to retirement is the only way to make sure you're prepared for the future.
Let's start by saying this: everyone starts somewhere. It's okay if you don't know too much about IRAs, what they are, or what they do right now. We're here to fix that! Through this post, we're going to talk about different types of IRAs, what/who they're for, and what they do! If you're young, IRAs can seriously work in your favor. If you're older, it never hurts to gain a little bit of extra knowledge that may still be able to help you or someone you love!
So, What's an IRA?
An IRA is a type of plan created by the government, designed to incentivize you to save for the future! IRA stands for Individual Retirement Account or Arrangement. There's a really fascinating reason behind why the A in IRA can be represented interchangeably by Account and Arrangement. We'll get more into that later.
Let's dissect the Acronym IRA: Individual means that the account or arrangement is owned and operated by one person. Retirement, which should be obvious, means that the IRA is intended for retirement savings. Lastly, an Account or Arrangement, which can change based on your circumstance, defines the IRA type you have.
An IRA isn't an investment itself; instead, it's more of a "place." An IRA is an account, similar to a savings account, that offers specialized features that make it an excellent spot to store your retirement money, investments, or assets. When worked into your financial plan, budget, and life plan, properly planned IRAs can become an integral part of planning for your financial future.
Essentially, an IRA is an account that's used to house assets, savings, or investments for retirement. The government gives them unique tax benefits, in the form of tax deferments, write-offs that act as an incentive to save. They also come with stipulations on when money can be withdrawn that are enforced with penalties and taxes. These stipulations are intended to incentivize account holders to not touch their money until they're of retirement age.
Account Versus Arrangement
Like I've mentioned, the government leaves the A in IRA a little up to interpretation. You can either have an Individual Retirement Account or an Individual Retirement Arrangement. These Accounts and Arrangements operate very similarly with many the same tax benefits, stipulations, and rules, but what they save can be very different. Generally, an account would hold anything that's strictly monetary, like savings or investments. At the same time, an arrangement could be used to store things that are more abstract, like business holdings or assets. It's easy to get hung up on the ambiguity of the last letter in the IRA acronym; however, speaking with a financial advisor is a quick and easy way to get a full and clear picture.
In the grand scheme of things, it isn't all that important for you to understand the conceptual differences between accounts and arrangements in the context of IRAs. Still, it does help you understand and have a working knowledge of IRAs.
Why Use an IRA?
Why would someone use an IRA instead of just a savings account or another type of retirement plan? That's a good question, and the answer mainly lies in taxes! The primary way that the government incentivizes or disincentivizes citizens to do (or not do) anything is by taxation. With tax hikes on goods, like cigarettes or fast food, the government attempts to disincentivize behaviors monetarily. Alternatively, if the government wants to incentivize citizens to partake in action, they could offer a tax break! With IRAs, as long as you don't take out your invested money before your retirement age, you get the benefit of delayed taxes! The same tax benefit can vary depending on what type of IRA you have!
The best (and only) surefire way to know that you're doing what's best for you is by speaking with a financial advisor or financial planner. Someone who has a clear big-picture view of what's going on in personal finance and can help guide you into making the best decision that will have the most significant impact on your finances.
The Types of IRAs
I've mentioned that there are various types of IRAs. For our purposes, the five most common IRAs are Traditional IRAs, Roth IRAs, SEP IRAs, Simple, and Rollover IRAs. These are all specifically built to fit into different life scenarios. The type of IRA that's best for you will depend quite a bit on your personal situation and where you are in your life.
The traditional IRA is what most people think of when they hear IRA. These are the original variation of the IRA created by the government in the '70s. With a traditional IRA, you're able to defer paying taxes while you're saving and instead pay taxes when you withdraw money at retirement. This allows you to maximize your investment, making the most out of compounding interest.
Another version of an IRA is a Roth IRA, which has speedily grown in popularity since its creation in the '90s. Instead of being yet another fancy financial acronym, Roth IRAs are named after senator Bill Roth. He sponsored the legislation that created this variation of the IRA. What makes these unique and increasingly popular among younger people is that the account holder only has to pay taxes on their initial investment, not when it's withdrawn. This allows the account holder to withdraw capital gains tax-free, which is potentially very lucrative if one begins investing using concepts like compounding interest and Dollar Cost Averaging earlier in life.
SEP IRAs are fantastic options for small business owners or freelancers. These raise your contribution limits quite a bit. A drawback of these is that if you employ others, you may be required to fund your employee's IRAs at similar rates as your own (which could be problematic if your business is small).
Popular among small business owners is the Simple IRA. Simple IRAs have a high contribution limit and are available to companies and businesses that employ less than one hundred people. These typically match contributions at a three percent rate as an incentive to employees to save.
Rollover IRAs are last on our list, which is very much purposeful! With all of these different IRAs, you're probably starting to get an idea of how messy they can be, which is only further complicated by changing jobs, having multiple IRAs, etc. The Rollover IRA allows the holder of numerous accounts or arrangements the option of consolidating all of their accounts/arrangements into one! If it took you a few tries to find that dream job, or if you just switch jobs a lot and have a bunch of IRAs open with different employers, this might be a great way to get all of your investments/savings into one spot!
Obviously, that's quite a bit of iRA talk; if at this point you're feeling confused or maybe even a little directionless, I'd like to go ahead and give you my spiel about the importance of talking to your financial advisor. We're here to help you make the right decisions and make sure you're informed about what you're doing.
What are Each Plan's Contribution Limits?
In an attempt to limit potential abuse of IRAs, the government sets "contribution limits." This is a fancy way of setting a limit on the amount of money you're allowed to put into an IRA annually. Different types of IRAs have different limitations on contribution, which change occasionally and can be a little bit confusing. With traditional or Roth IRAs, you're allowed to contribute $6,000 annually or $7,000 if you're over fifty years of age. SEP IRAs allow you to contribute $56,000 or up to twenty-five percent of your income annually. Simple IRAs set their limit at $13,000. Rollover IRAs have a different type of limitation. Instead of an annual contribution limit, you're limited to rolling over one account per year.
Potential Issues of Rollover Plans
As with all great things, there are always drawbacks to be considered. Rollover IRAs aren't an exception to this. Potential issues with rollover IRAs are fees, expenses, and protection…(Fees, Expenses, Protection - needs to be weighed beforehand *I can write this)
Are IRAs Risky?
Often while I'm discussing the potentiality of using an IRA, I'm asked about their dangers. While anything to do with investment certainly entails some amount of risk, IRAs are not inherently risky. As mentioned before, IRAs are more of a "where" than a "what"; they're a holding account for whatever you put inside of them. If your investments are risky, the IRA does become risky; however, it is not dangerous on its own. Yet, IRAs have rules that you must follow if you want to fully reap their benefits and avoid taxes and penalties.
A Few More IRA Facts
You may find yourself in a situation where you're opening multiple IRAs. This naturally leads people to wonder how many IRAs they can have; the answer is… as many as you'd like. It might not make a ton of sense to have boatloads of IRAs; however, you won't be penalized for having them. Though you can have as many IRAs as you'd like, that isn't a loophole to get around contribution limits. Whether you have one or a hundred traditional IRAs, you're still limited to six thousand dollars of contribution annually if you're under seventy.
Speaking of those pesky contribution limits, we never really discussed what would happen if you over-contributed. If you over-contribute, you're liable for penalties and taxes. Unfortunately, you may also be taxed each year that the over-contribution is left in your account, which could quickly become a burden. While there's a base-level contribution limit, that number can vary depending on other factors like your age or income level.
How do Pensions and IRAs Relate?
In my recent article, How Pensions Work With Your Financial Plan, I talk all about what pensions are, how they work, as well as the benefits and risks associated with them. Pensions are an alternative to IRAs. However, they could also work hand-in-hand. Pensions are, unfortunately, often tied to your employer. They aren't necessarily available to everyone, but speaking with a financial professional could open your eyes to how you could make pensions and IRAs operate harmoniously.
A CERTIFIED FINANCIAL PLANNER™ Can Create a Comprehensive Financial Plan To Help You Incorporate IRAs into Your Financial Plan
Working towards retirement shouldn't include guesswork, but often people feel left in the dark when it comes to their own retirement accounts, IRAs, pensions, etc. If it isn't apparent yet, IRAs are a complicated world. While this article is relatively in-depth for the average person, it only begins to scratch the surface of IRAs' details. If you're finding yourself overwhelmed by any of this information, I'd highly recommend speaking to a financial professional like myself. Please feel free to call or email and schedule an appointment with me. I work with my clients to create custom-tailored financial plans that fit their lifestyle and goals.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.