What Is an Individual Retirement Account (IRA)?

An individual retirement account (IRA) is a tax-advantaged investing tool that individuals use to earmark funds for retirement savings. As a black person this account is going to be key for people living NOW. It is a known fact that Social Security is running out and even though we pay taxes depending on that would be extremely foolish at this point. Having an IRA account can be beneficial in more than one way.

KEY TAKEAWAYS

1. IRAs are tax-advantaged investing tools for individuals to earmark their retirement savings.
2. Depending on the individual’s employment status, IRAs can be of various types and have different tax liabilities.
3. If you withdraw money from an IRA before age 59½, you are usually subject to an early-withdrawal penalty of 10%.
4. There are income limitations for contributing to Roth IRAs and deducting contributions to traditional IRAs.
5. Rules regarding maximum contributions and income limits for IRAs change each year.

There are Several Types of IRAs

Traditional IRA

In most cases, contributions to traditional IRAs are tax-deductible. If someone puts $6,000 into an IRA, that person’s taxable income decreases by the amount of the contribution. However, when that individual withdraws money from the account during retirement, those withdrawals are taxed at their ordinary income tax rate. In other words, you can deposit money and when you do your taxes it will decrease how much taxes you pay. However, when you go to use that money you will be taxed at that point for the money you take out.

As of 2020, annual individual contributions to traditional IRAs cannot exceed $6,000 in most cases. If you are 50 or older, you can contribute up to $7,000 per year using catch-up contributions.

Roth IRA

Roth IRA contributions are not tax-deductible, but qualified distributions are tax-free. You contribute to a Roth IRA using after-tax dollars, but you do not face any taxes on investment gains. So, you will pay taxes on the money that you invest beforehand. However, when you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roth IRAs also do not have (required minimum distribution) or RMDs. If you don’t need the money, you don’t have to take it out of your account. You can still contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.

SEP IRA

Self-employed individuals, such as independent contractors, freelancers, and small-business owners, can set up SEP IRAs. The acronym SEP stands for “Simplified Employee Pension.” A SEP IRA adheres to the same taxation rules for withdrawals as a traditional IRA. For 2020, SEP IRA contributions are limited to 25% of compensation or $57,000, whichever is less. In other words you can invest up to 25% of your pay into this account as long as it doesn’t exceed $57,000 in a year. In 2021, it goes up to $58,000.

SIMPLE IRA

The SIMPLE IRA is also intended for small businesses and self-employed individuals. The acronym SIMPLE stands for “Savings Incentive Match Plan for Employees.” It also follows the same taxation rules for withdrawals as a traditional IRA. Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions as well. So, this works more like a 401k on a typical job. All the contributions are tax-deductible, potentially pushing the business or employee into a lower tax bracket.