An IRA is a way to save money with huge tax breaks. Almost anyone can put money in some kind of IRA. IRAs are easy to open and maintain.
There are penalties for taking money from most kinds of IRAs before retirement. However, money in IRAs can be used for certain expenses like education, home buying and medical costs without penalties. Generally speaking, once money is put into an IRA, it’s a good idea to leave it there until retirement.
What is an IRA?
An IRA is an “Individual Retirement Account.” It’s just a place to save money that comes with big tax breaks. You can save money without an IRA, but then you don’t get the tax savings.
An IRA itself is not an investment. Money in an IRA can be kept in a savings account, stocks, bonds or other assets. The investing actually happens after the IRA is created.
Why Put Money in an IRA?
Putting money in an IRA is a good idea because it’s a great way to save a LOT of money on taxes. A traditional IRA gives a tax break of $5,500 a year to people under age 50.
For example, let’s imagine two savers: one who puts $5,500 a year in a plain old savings account and one who puts $5,500 a year in an IRA savings account.
Let’s say both savers have taxable annual income of $50,000 a year. Deductions aside, if the tax rate is 25%, they’d pay $13,750 a year in federal income tax ($50,000 x 25%).
However, because one of them puts $5,500 in an IRA each year, her taxable income is lowered to $44,500 ($50,000 – $5,500). That means her yearly tax bill is only $11,125 ($44,500 x 25%). Because of her IRA, she saves $2,625 on her taxes every year. After 40 years, that’s a tax savings of $105,000, just for putting the money in an IRA instead of a regular savings account!
Also see: Traditional IRA vs Roth IRA
What are the Different Kinds of IRAs?
There are several different kinds of IRAs, including:
- Traditional IRAs give tax breaks in the year the money is put into the IRA.
- Roth IRAs give tax breaks during retirement.
- SIMPLE IRAs allow contributions by small business owners and their employees.
- SEP IRAs are for self employed people and freelancers.
- Coverdell ESAs (formerly known as Education IRAs) are for saving money for certain education expenses like tuition, books, supplies, and room and board.
Who Can Put Money in an IRA?
Just about anyone can put money into some kind of IRA. The list below shows info on who can put money into different kinds of IRAs:
- Traditional IRAs: Just about anyone can put money in a traditional IRA as long as they have taxable income and are younger than 70 1/2.
- Roth IRAs: Nearly everyone can put money in a Roth IRA, as long as they have less than a certain annual income. (For 2015, all single taxpayers with less than $105,000 in modified adjusted gross income can contribute to a Roth IRA.)
- SIMPLE IRAs: Small business owners can put money in their own SIMPLE IRAs and in their employee’s SIMPLE IRAs. Employees can also put money in their own SIMPLE IRA accounts that are set up by their employers.
- SEP IRAs: Self employed people and small business owners can contribute to SEP IRAs. (Unlike SIMPLE IRAs, employees of small businesses can’t contribute.)
- Coverdell ESAs: Anyone can put money in a Coverdell ESA.
Also see: 2014 Roth IRA Rules
How Do I Open an IRA?
It’s easy to open an IRA. Any bank or other financial institution like a brokerage firm can open an IRA for you. Just contact the financial institution’s sales department and tell them you want to open an IRA.
One thing to watch for is fees, because some banks have higher fees to open and maintain IRA accounts than others. For example, Bank of America has no annual IRA fees. However, they do have transaction fees on some accounts of 1 to 3 cents per $1,000 of principal. Certain transactions may even have fees as high as 10%.
How Much Money Should I Put in an IRA?
Most financial advisors recommend putting as much money into an IRA as the law allows. Generally speaking, the more you put into an IRA, the more you save on taxes.
In 2015, traditional and Roth IRAs had contribution limits of $5,500 for those under age 50. Those age 50 and older can make “catch up” contributions to IRAs of an additional $1,000 per year.
For more info on IRA contribution limits, click here.
How Do I Invest the Money in My IRA?
Most financial advisors tell their clients to diversify investments as much as possible. Money in the U.S. stock market is not diversified because all stocks can crash at once.
Putting some of the money in an IRA into stocks and some in bonds is a good idea. In most cases, when stocks crash, bonds go up. However, since there are some situations when both stocks and bonds can crash, spreading the money between U.S. stocks and bonds and foreign stocks and bonds adds another layer of protection. Finally, it’s not a bad idea to keep some percentage of the IRA in cash, savings or other investments.
The financial institution where you open your IRA will be able to help you make decisions about how to invest the money that best fit your needs.
Also see: 8 Easy Ways to Save Your Way to $1.7 Million
When Can I Take Money Out of My IRA?
Different IRAs have different rules about when money can be taken out. Taking out money before the deadline generally results in a 10% penalty. The list below shows when money can be taken out of the different kinds of IRAs:
- Traditional IRAs: Money can be taken out of traditional IRAs only after age 59 1/2.
- Roth IRAs: Money put into Roth IRAs can be taken out at any time. Earnings on money in Roth IRAs can’t be taken out until after age 59 1/2.
- SIMPLE IRAs: Money in SIMPLE IRAs can’t be taken out until after age 59 1/2.
- SEP IRAs: Money in SEP IRAs can’t be taken out until after age 59 1/2.
- Coverdell ESAs: Money can be taken out of Coverdell ESAs at any time to pay for qualified education costs, including college, secondary school and elementary school costs.
Also see: Why I Pulled Money Out of My Roth IRA
Are There Penalties for Taking Money From an IRA too Early?
There’s generally a 10% penalty for taking money from an IRA before age 59 1/2. Here are a few rules on penalties for taking money from IRAs too early:
- Penalty for taking money from most IRAs before age 59 1/2: 10%
- Penalty for taking money from Roth IRA before age 59 1/2: No penalty in most cases.
- Penalty for taking money from Coverdell ESA for reasons other than qualified education expenses: 10%.
- The 10% early withdrawal penalty is waived if money taken from an IRA is used for qualified education expenses, to buy your first home, or for certain medical expenses. However, the money taken out is taxed as income.
- There’s a 25% penalty for money taken from an SEP or SIMPLE IRA in the first two years after the IRA is created.
What if I Have to Take Money From My IRA Before I Retire?
There are certain times it’s O.K. to take money from an IRA before age 59 1/2. The IRS penalties are dropped if someone needs to take money from their IRA early to pay for education, to buy their first home or for high medical expenses.
The IRS defines high medical expenses as any medical cost that’s more than 7.5% of a taxpayer’s Adjusted Gross Income (AGI).
Also see: How to Start Saving for Retirement the Easy Way
When Do I Have to Take Money From My IRA?
With most IRAs, account holders have to start taking money out at age 70 1/2. The one exception is Roth IRAs. With Roth IRAs, the money can be left in as long as the account holder wants.
After age 70 1/2, complex rules decide how much money has to be taken out of an IRA each year.
How is My IRA Money Taxed When I Retire?
Taxes on money in an IRA after retirement depend on the type of IRA. The list below shows how money in different kinds of IRAs gets taxed during retirement:
- Traditional IRAs: Money taken from traditional IRAs after age 59 1/2 is taxed as normal income.
- Roth IRAs: Money taken from Roth IRAs is generally tax free.
- SIMPLE IRAs: Money taken from SIMPLE IRAs in retirement is taxed as income.
- SEP IRAs: Money taken from an SEP IRA after age 59 1/2 is taxed as regular income.
- Coverdell ESAs: Money taken from Coverdell ESA accounts is tax free as long as it’s used for qualified education expenses like tuition, books, supplies and room and board.
Should I Use IRA Money to Pay off Debt?
You shouldn’t use money in an IRA to pay off debt unless it absolutely can’t be helped. To explain why, here’s an example:
Let’s say you have $10,000 in a traditional IRA and you use it to pay off debt. If you’re younger than age 59 1/2, you’ll pay a 10% penalty on the money, so you’ll only get $9,000 from the IRA and the IRS will take $1,000. Next, you’ll pay taxes on the money. Assuming a 25% tax rate, that’s another $2,250 gone, leaving you with only $6,750 of your original $10,000. Finally, if you’d left that $10,000 alone, invested at 8% for 30 years it would have grown to $100,626.
The moral of the story is, if it can be helped at all, leave money in an IRA alone and let it grow. Don’t use it to pay off debt.
Also see: 6 Easy Ways to Reduce Credit Card Debt
Can I Use IRA Money to Pay for College?
Money in an IRA can be used to pay for college, high school and even elementary school expenses. It can also be used to pay for some medical costs and for buying your first home.
Although money taken from an IRA to pay for the reasons listed above isn’t penalized at a rate of 10%, it’s still taxed as ordinary income. In most cases, it’s better to use a Coverdell ESA to pay for education costs than to use an IRA. That’s because money taken from a Coverdell ESA to pay for college is generally tax free.