Retirement is a life period where expenses go up, and income reduces. Without a retirement plan, it is easy to spend all your money through your peak earnings 30s and 40s. While many investment plans can serve your retirement funds, we want to focus on the individual retirement account (IRA).
An individual retirement account is a special saving account opened by income earners to save and invest for the long term. You can only operate an IRA with earned income. Income from interests, social benefits, dividends, or child support is not allowed.
Individual retirement accounts can be opened through your local bank, an online brokerage, an investment company, and a personal broker.
What is an Individual Retirement Account (IRA)?
An individual retirement account is a special savings account used for long-term savings and investments. Don’t confuse it with earned income credit; if you are not familiar with this concept, we recommend finding out what is earned income credit.
If you’ve earned income, you can step into any financial institution and open an IRA. You can also decide to invest your savings in stocks, ETFs, bonds, mutual funds, and other financial products.
After you’ve chosen your preferred investment plan, your financial institution makes large-scale investments and rewards the account with a steady 7-10% annual return. However, some accounts are self-directed, and investors can make unilateral decisions. Before investing in an individual retirement account, you should consider your tax bracket and seek expert advice.
There are a few difficult requirements when it comes to opening an individual retirement account. The most significant one is the withdrawal penalty. If you take out money before the age of 59.5, you have to pay 10% charges. However, this rule does not apply to withdrawal for college debt expenses and first home purchases.
Types of IRAs
There are different types of individual retirement accounts, and they all have various percentage returns, deposit limits, tax benefits, loan allowances, and default penalties. The most popular individual retirement account types are the traditional IRA, Roth IRA, SEP-IRA, and Simple IRA.
These types of IRAs are common across approved financial institutions. All of these models have their pros and cons. If you are planning to open an individual retirement account, we have explained the different types in detail. You can easily select one that suits you and your budget best right now.
All funds put in a traditional individual retirement account are not subject to tax. This means if you deposit $5,000 in your traditional IRA in 2024, that amount becomes tax-deductible.
Therefore, if your total taxable income for the year is $70,000, your ordinary income tax rate will be calculated at $65,000. However, when you withdraw the money (post-retirement), it will be subject to tax per your ordinary-income rate.
If you already have a retirement plan at your place of work, your MAGI will determine how much of your traditional IRA is tax-deductible. The highest amount you can contribute to a traditional account is $6,000.
If you are older than 49 years old, you can save up to $7,000 annually. You can have several accounts opened at different financial institutions. But the total funds in all the accounts cannot be more than $6,000/$7,000.
If you opened an individual retirement account so you can have investment funds in your retirement years, then a Roth IRA is the perfect choice for you.
With this type of account, you can only deposit your earned income after it has been taxed. This means investment gains on a Roth IRA are not tax-deductible. You can also withdraw contributions (not earnings) without any penalty or taxes.
There are income limits that must be met before you are eligible to contribute to a Roth IRA. If you earn more than $144,000/yr as a family head or single, you can’t operate a Roth IRA. If you are filing as a married couple, the income limitation is $214,000. Like in the traditional individual retirement account, you can only contribute up to $6,000/$7,000 per year.
If you work for a reputable organization, you probably have a 401k fund running for you. However, if you are an independent consultant, small business owner, freelancer, or contractor, the ideal individual retirement account for you is the SEP-IRA. SEP simply means simplified employee pension, and it is designed to help private business owners save for retirement.
The same withdrawal tax that applies in a traditional IRA also applies to a SEP-IRA. If you withdraw before you turn 59.5, you pay a 10% charge per withdrawal. One major advantage of the SEP-IRA is the contribution limit.
You can contribute up to 25% of your yearly compensation, up to $61,000. If 25% of your yearly income is more than $61,000, the contributions are limited to that amount. If you are a business owner who employs freelancers, you can open SEP IRAs for them. Nevertheless, the employees themselves can’t contribute to the account.
Like the SEP-IRA, the Simple individual retirement account is also designed for independent consultants, freelancers, and self-employed persons. The term savings means an incentive match plan for employees. Under the SEP-IRA, employees are not allowed to contribute to the IRA opened for them by their employer.
However, under the simple IRA, employees can make contributions to their accounts. All the funds invested in a simple IRA (from both employer and employee) are tax-deductible. The total amount you can contribute to a simple IRA is $14,000 per annum.
But, if you are between 50 to 59 years old, you can contribute up to $17,000 per annum. The same tax penalty for withdrawals in the traditional account also applies to the simple one.
If you run a small business, opening simple individual retirement accounts for your employees will cost you less than a 401k.
Table 1.1- Comparing Individual Retirement Accounts
|2024 Contribution Limit
|Tax Deductible Deposits
|<50 years old- $6,000 >50 years old- $7,000
|<50 years old- $6,000 >50 years old- $7,000
|Lesser of $61,000 or 25% of annual income
|<50 years old- $14,000 >50 years old- $17,000
Should I use IRA?
There are certain benefits you enjoy when you open an individual retirement account. The biggest is the tax advantages. All individual retirement accounts offer some sort of tax break that will reduce your tax liability now or in the future.
Investment returns from your account funds are not taxable, and you don’t need to worry about losing your money during economic downturns. All individual retirement accounts are insured by the Federal Deposit Insurance Corporation (FDIC), which covers customer deposits (up to $250,000) per account.
If you are thinking of opening an IRA, the best time is between the ages of 30 to 55. By age 30, your yearly income should have stabilized, and you have enough disposable cash to invest consistently. Furthermore, the money will have ample time to grow and accumulate investment returns over the years.
You can start an individual retirement account at age 55. This will get you a higher catch-up contribution limit. Your individual retirement account is meant for your retirement years and the best time to withdraw from it is after age 60.
If you withdraw from your account before you clock 59.5, you will have to pay a 10% early withdrawal charge alongside additional taxes. However, there are special exceptions where you can withdraw money without incurring any penalty.
Education expenses, medical expenses, unusual life events, and so on. It is important to confirm all the approved withdrawal permits of your IRA before opening an account.
401(k) vs. IRA
The major difference between a 401(k) and an individual retirement account is the body providing them. While an IRA is opened, funded, and managed by the individual, a 401(k) is purely run by employers.
A 401(k) is a retirement savings framework set up by employers for their employees. Once you are 21 years of age and you have served in an organization for more than a year, you are eligible for a 401(k)-retirement account. The 401(k) is governed by the Employee Retirement Income Security Act (ERISA) federal law.
The contribution limits for 401(k) and IRA also vary. If you are under 50 years old, you can only contribute $6,000/yr to your IRA (this applies to both traditional and Roth accounts). Under the 401(k), you can contribute up to $20,500. If you are over 50, you can contribute up to $ 7000 under the IRA plan and $27,000 under the 401(k). Individual retirement accounts are generally more flexible than 401(k)s.
Can you borrow from an IRA?
The IRS doesn’t approve borrowing from individual retirement accounts. However, you can withdraw from your individual retirement account. So, the real question is, can you borrow from an IRA without penalty? The answer is no.
Withdrawing funds from an IRA before maturity will cost you a 10% early withdrawal penalty alongside regular ordinary income taxes. Nevertheless, several conditions exist for withdrawing savings from the IRA without penalty. We have outlined them below.
- l the user is 59½ or older
Once you have earned income, you can open an individual retirement account and contribute to it. You can keep contributing to this account yearly until you are 59.5 years old, and then it is eligible for withdrawal. When withdrawing at age 59.5 or older, you will enjoy the full benefits of an IRA.
- l the user qualifies for an exception
In special cases, you can withdraw from an individual retirement account without incurring penalties. If you have uninsured medical expenses, Unpaid health insurance premiums due to unemployment, college expenses, disabilities, Inherited accounts, or military duty for at least 190 days. Can you borrow from an IRA to buy a house? The answer is yes. However, you must be a first-time home buyer, and you can only withdraw up to $10,000
- l the user has a Roth IRA
Can you borrow from a Roth ira? The answer is yes. With a Roth IRA, you can withdraw from your contributions without incurring penalties or taxes. This is because the earned income was taxed before it was used to fund the account. But investment gains are not up for withdrawal.
- l the user can replace the money in 60 days or less
The easiest way to get an ira loan is to withdraw it to another approved account and return it within 60 days. The IRS allows account holders to move money out of their individual retirement accounts for 60 days without penalty. However, once the money is not returned within 60 days, you are subject to 10% charges and tax liability.
When should I borrow against my IRA?
The honest answer is never. Getting a loan against your individual retirement account is impossible because you cannot pledge them as collateral. The IRS only allows for distributions from individual retirement accounts. This means if you remove money from this account, you cannot put it back.
You will have to pay penalty charges, and you also have reduced funds for your retirement. It is better to find other alternatives for your current financial needs. However, if you need cash, you can do a few things with your individual retirement account.
You can use the 60-day rollover rules while following strict IRS rules. Your Roth IRA is also a good option for borrowing because no tax liabilities are involved. If you want an easy ira loan, you should open a Roth IRA. You can borrow against workplace retirement plans like the 401(k).
What happens if I fail to pay back the IRA loan?
As we said earlier, you can take out money from your individual retirement account and enjoy a 60-day rollover without penalties. However, if you fail to return the money after the defined period, it becomes a taxable distribution on your account. If you can only pay part of the ira loan, the unpaid amount will be subject to tax.
Another complication is that you have to return the same assets you took. You cannot redeposit stock or other financial assets if you withdraw cash from your account.
If the custodian of your individual retirement account invests your money in mutual funds or annuities, there may be charges applied if you want to withdraw money prematurely, and you have to pay them. Under certain conditions, the deadline may be extended. However, this will already be predetermined, and it must adhere strictly to IRS rules.