You can build a nest egg for retirement faster and more easily if you qualify for tax breaks for your retirement savings. Individual retirement accounts allow workers with earned income to minimize taxes as they save for retirement.
The Benefits of an IRA:
— Defer paying income tax on traditional IRA deposits.
— Investment earnings are not taxed each year while the money is in the account.
— Roth IRAs provide tax-free withdrawals in retirement.
What Is an IRA?
An IRA is a retirement saving and investment account that provides tax benefits to participants. While the IRA contribution limits are lower than 401(k) plans, many workers are able to build up a large balance by rolling over their 401(k) plan to an IRA each time they change jobs.
IRA Contribution Limits
The IRA contribution limit is $6,000 in 2022. Workers age 50 and older can make catch-up contributions of up to an additional $1,000, for a total contribution of $7,000. These limits apply to traditional and Roth IRA deposits and contributions to both types of accounts in the same year.
IRA Eligibility Requirements
You must have earned income to be eligible to contribute to an IRA. However, married couples can fund an IRA in each of their names, even if only one spouse works, by opening a spousal IRA.
Your ability to make a tax-deductible traditional IRA contribution is limited if you have access to a 401(k) plan or similar type of retirement account at work and earn more than $68,000 ($109,000 for couples), and it’s eliminated if you are paid more than $78,000 ($129,000 for couples). If only one member of a married couple has access to a 401(k) plan at work, the IRA tax deduction is phased out if the couple’s income is between $204,000 and $214,000 in 2022.
You can’t make Roth IRA contributions if your income exceeds $144,000 ($214,000 for married couples) in 2022, and the deduction is phased out for those who earn more than $129,000 ($204,000 for couples).
IRA Contribution Deadline
You have until your tax filing deadline, which is usually around April 15, to make an IRA contribution. For deposits made in January through April, you will need to specify whether the contribution is for the previous tax year or the current calendar year. A traditional IRA contribution can be made shortly before filing your taxes in order to reduce the tax you owe or boost your refund.
Should You Use a Traditional or Roth IRA?
Traditional and Roth IRAs have different tax benefits and withdrawal requirements.
Traditional IRA. A traditional IRA allows you to defer paying income tax on your contributions until they are withdrawn from the account. There’s a 10% early withdrawal penalty on distributions before age 59 1/2 unless the money is used for several specific purposes, and withdrawals are required after age 72.
Roth IRA. Roth IRA contributions are made with after-tax dollars. You don’t have to pay tax on the investment earnings in the account each year, and withdrawals after age 59 1/2 from accounts that are at least five years old are tax-free. Roth IRA withdrawals are not required in retirement, and heirs may also be eligible for tax-free distributions.
You can withdraw your contributions from a Roth IRA that is at least five years old before age 59 1/2 without penalty if you need it. “The goal is to let these accounts grow tax-free until retirement, but if life happens, they have the flexibility to help out the family in a pinch,” says Justin Porter, a certified financial planner and founder of Porter Wealth Management in Atlanta. “You can take out your contributions to a Roth IRA tax- and penalty-free.” However, early withdrawals of investment earnings could trigger taxes and penalties.
To decide which type of IRA is best for you, compare your current tax rate to an estimate of your retirement tax rate. “The difference between a traditional and Roth IRA is the timing of when taxes are paid,” says Luiz Augusto Pacheco, a certified financial planner at Brainvest Wealth Management in Miami. “Traditional IRA taxes are due when the investor starts withdrawing from it. Roth IRA taxes are paid upfront. If you have a higher income, the traditional IRA might be a better solution.”
If you have a low tax rate now, a Roth IRA allows you to pay your current tax rate on your retirement savings and avoid taxes in the future. You can also hedge your bets about future tax rates by contributing to both types of accounts.
Rolling Over to an IRA
In addition to direct contributions, IRAs can be funded by rolling over your 401(k) balance each time you change jobs. Transferring your retirement savings to an IRA allows you to maintain the tax benefits of your 401(k) plan while also shopping around for the best investment options and the lowest investment fees. When moving your money, initiate a trustee-to-trustee transfer in order to avoid potential taxes and penalties on the transaction.
How to Open an IRA
You can open an IRA at most financial institutions, including banks, mutual fund companies and brokerages. IRAs typically have a wide selection of investment options, and you can compare several providers to find the funds you want and reasonable fees.
“If an individual prefers the self-directed investing approach, a large discount brokerage firm would be a great place to look,” says Jared Tanimoto, a certified financial planner and president of Ascent Wealth Advisors in Irvine, California. “There’s no one best-fit investment type for all investors, but typically low expense ratio ETFs and mutual funds are a great option to look for when investing in a Roth IRA.”
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Update 06/02/22: This story was published at an earlier date and has been updated with new information.