Financial Planning 101 - What You Need To Know About IRAs
Last post we talked about 401k plans. In this edition, we will focus on IRA (Individual Retirement Account) accounts which are the next most popular type of retirement account. There are over 36 million of these accounts in the U.S. according to the IRS containing $9.8 trillion which is nearly one-third of all retirement assets.
For the most part, the key attributes of IRA accounts are very similar to 401k plans. I won’t get into the details of explaining again the various terms, for that you can refer to the previous post. There are some differences though and I will highlight both the key similarities and differences here.
IRAs are typically funded in one of several ways. It can either be someone’s primary retirement savings account if they don’t have access to one from an employer, as a supplement to their 401k or as a result of a 401k rollover.
· Like the 401k, the IRA is a retirement plan where people can contribute pre-tax dollars that grow tax-deferred.
· Withdrawals before the age 59 ½ (with a few exceptions) incur a 10% penalty.
· RMDs are mandatory starting at age 72.
· All withdrawals are considered taxable income.
· Both 401k and IRA accounts may have a Roth option.
· As the title states the IRA is an individual account. This is not an employer sponsored account. These are accounts you can open on your own at a brokerage firm like Schwab, Vanguard or Fidelity or with an advisor through their firm.
· The contribution limits for an IRA are much lower than those for an IRA. For 2020 the contribution limit is $6,000 and the catch-up amount is an additional $1,000 compared to the $19,500 and $6,500 for the 401k.
· The $6,000 contribution limit is tied to that amount or your earned income whichever is less.
· Unlike a 401k there are income limits for being able to make tax deductible contributions to an IRA. For those who are participating in a workplace retirement plan the ability to deduct your contributions phase out between $104,000 and $124,000 for those filing taxes as married joint. The phase-out is 0-$10,000 for those filing married separately. For those individuals who are don’t have access to a workplace plan but are married to someone who does, the phase out is $196,000 - $206,000. If neither spouse has access to a workplace plan then there is no income limit.
· Since an IRA is not an employer plan the contributions do not come directly from your paycheck and do not need to be consistent. Contributions can be made periodically or even in one lump sum.
· Contributions can be made by April 15th of the following year and still be used a deduction for income tax purposes for the previous year.
· For a traditional IRA account there is no employer match since, again, it is an individual account. This combined with the lower contribution limits can make it difficult to accumulate a larger balance as quickly as one can with a 401k.
· There are no vesting timetables for IRA accounts. Since all of the contributions came from you all of the funds are yours immediately.
· One major upside for an IRA is the amount of investment options that are available. Whereas a 401k has a limited number of mutual funds to select from, an IRA can have an almost unlimited number of investment options. Almost any investment option that is available through your custodian are fair game in an IRA. This includes a choice of thousands of mutual funds, ETFs and individual stocks and bonds.
Rollover of 401k to IRA
When workers leave their job they have several options on what they can do with their 401k plans.
1. Choose to leave it with your former employer
2. Cash it out – If you select this option be aware that the entire amount will be taxable income to you and if you are under age 59 ½ there will be an additional 10% penalty.
3. Roll it over to an IRA. The best way to do this is via a direct rollover. This is where the funds from your 401k plan are sent directly to your new IRA custodian. This way you avoid the rollover being considered a withdrawal and subject to income taxes and penalties. If the funds are sent to the account holder there is a 60-day window to forward on to the new custodian to avoid taxes and penalties. Otherwise, the entire transfer amount will be considered the same as a cash-out.
Changes with SECURE Act
Right before the end of 2019 Congress passed and the President signed into law the SECURE Act which contains some rule changes to how these plans are used. Here is a summary of the key updates:
· The age cap for contributions was previously 70 and is now unlimited as long as there is earned income
· The previous age for beginning to take RMD from the account was 70 ½, it is now 72
That completes our overview of IRA accounts. If you are one of the 36 million IRA account holders in the United States I hope this helps explain the basics of the plan to you. If you have any additional questions you can request a copy of your plan’s SPD (summary plan description) from your employer which will have all of the rules for your specific plan.
As always, if you have any questions regarding this topic or anything else with your personal finances please let us know at firstname.lastname@example.org. Look for the next blog post in the coming weeks on Roth accounts.
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