Investing Personal Finance

Everything You Need to Know About IRAs But Were Afraid to Ask

Beth Trach
Written by Beth Trach

Everything You Need to Know About IRAs But Were Afraid to Ask

Saving for retirement is one of the most important things you can do for yourself — especially if you’d like to stop working some day. But did you know that 35 percent of the workforce doesn’t have access to an employer-sponsored 401(k) plan?

If you’re one of that unlucky crowd, you need to go it alone for your retirement. Fortunately, a 401(k) isn’t the only way to build your retirement next egg — it just happens to be the most famous. If you’re a gig worker, small business owner or stay-at-home parent, you still have options.

So how do you choose? Here’s what you need to know about the major retirement plans available to individuals so you can make the right choice for your savings.

Traditional IRA

A traditional IRA (Individual Retirement Account) is a tax-advantaged saving program that lets you invest your earnings without paying taxes on them. To get that benefit, though, you can only withdraw the money after age 59 1/2; otherwise, you have to pay penalties.

  • Annual Contribution Limit: $5,500 under age 50; $6,500 age 50+
  • Tax Info: You put money into an IRA before you pay taxes on it, meaning that you can deduct the full amount of your contributions from your state and federal income taxes. Principal and earnings are taxed as regular income (not capital gains) only when you take distributions (withdrawals).
  • Distribution Info: You can begin to take payments at age 59 1/2; you must start taking a required minimum distribution starting at age 70 1/2.
  • Penalties: If you take out money before age 59 1/2, you’ll pay the regular taxes you owe plus an extra 10 percent penalty. There are some exceptions, such as money withdrawn to pay college tuition, funeral expenses or medical expenses.
  • Loans: Unlike a 401(k), you can’t borrow money from an IRA.

Roth IRA

A Roth IRA is another tax-advantaged savings plan, but it’s the timing of the taxes that make it unique. With a Roth, you pay taxes on your earnings now, but you’ll never be taxed on the money again. For this to work for you, you should expect to be in a lower tax bracket today than you will be during your retirement.

  • Annual Contribution Limit: $5,500 under age 50; $6,500 age 50+
  • Tax Info: You put money into a Roth IRA after you pay taxes on it. This means that you will be able to deduct your distributions from your federal and state income tax. You are never taxed on the earnings.
  • Distribution Info: You can begin to take payments at age 59 1/2; you must have the plan in place for five years before taking tax-free distributions.
  • Penalties: If you take out money before age 59 1/2, you’ll pay the regular taxes you owe plus an extra 10 percent penalty. There are some exceptions, such as money withdrawn to pay college tuition, funeral expenses or medical expenses.
  • Loans: Unlike a 401(k), you can’t borrow money from an IRA. However, you can withdraw your principal without penalty at any time with a Roth IRA.

SEP-IRA

An SEP-IRA (Simplified Employee Pension IRA) is designed for small business owners. If you want to open an account for yourself, you’ll also have to contribute an equal amount to each of your employees’ accounts — so it’s best if you’re a solo artist (though you can deduct contributions to your employees’ accounts on your business taxes).

  • Annual Contribution Limit: 25 percent of your total self-employed income up to a $54,000 limit
  • Tax Info: You put money into an IRA before you pay taxes on it, meaning that you can deduct the full amount of your contributions from your state and federal income taxes. Principal and earnings are taxed as regular income (not capital gains) only when you take distributions (withdrawals).
  • Distribution Info: You can begin to take payments at age 59 1/2; you must start taking a required minimum distribution starting at age 70 1/2.
  • Penalties: If you take out money before age 59 1/2, you’ll pay the regular taxes you owe plus an extra 10 percent penalty. There are some exceptions, such as money withdrawn to pay college tuition, funeral expenses or medical expenses.
  • Loans: Unlike a 401(k), you can’t borrow money from an IRA.

Solo 401(k)

A Solo 401(k) plan is designed specifically for self-employed people with only one possible employee: your spouse. It has the highest contribution limits available, and you get the perks of a 401(k), including being able to set up a loan to borrow funds without paying a penalty.

  • Annual Contribution Limit: $55,000 under age 50; $60,000 age 50+
  • Tax Info: You can set up a Solo 401(k) to be taxed like a traditional IRA (taxed when you withdraw) or like a Roth IRA (taxed before you contribute).
  • Distribution Info: You can begin to take payments at age 59 1/2; you must start taking a required minimum distribution starting at age 70 1/2.
  • Penalties: If you take out money before age 59 1/2, you’ll pay the regular taxes you owe plus an extra 10 percent penalty. There are some exceptions, such as money withdrawn to pay college tuition, funeral expenses or medical expenses.
  • Loans: You can borrow money from your Solo 401(k) without penalty as long as you pay it back with interest within a designated time frame.

At the end of the day, it’s far less important which type of retirement account you choose than the fact that you open one at all. The earlier you start to save, the better off you’ll be, since you can take advantage of the years to allow your earnings to compound. So open an account today, set up an automatic contribution, and you’ll build up your nest egg in no time!

About the author

Beth Trach

Beth Trach

Elizabeth Trach is a writer and editor living in Newburyport, MA. She also sings in a band, grows almost all her own food, and occasionally even cooks it. You can catch up on all her adventures in frugal living and extreme gardening at Port Potager.

Leave a Comment