Wealth, like a tree, grows from a tiny seed…The sooner you plant that seed the sooner shall the tree grow.
What is an IRA?
IRA stands for Individual Retirement Account and that’s exactly what it is. Similar to a 401(k) or a pension, it’s a savings/investment account that you contribute to in saving for your traditional retirement years. I say traditional because the FIRE (Financial Independence Retire Early) movement has shaken up what “retirement” and “retirement age” means to some people. However, the IRS (with regard to an IRA) says retirement age is 59½. More on why that number matters in the next section.
Focusing on the “Individual” part of IRA, it’s an investment account that you open on your own, independent of an employer. This is unlike 401(k) or 403(b) retirement plans that are employer sponsored, meaning you have to work for the company that’s sponsoring the 401(k) or 403(b) plan.
How does an IRA work?
The traditional IRA allows you to contribute up to a certain amount of pre-tax dollars to an investment account. This means that whatever you contribute to an IRA for a certain year can be deducted from your taxable income for that year. In 2020, you can contribute up to $6,000 into an IRA (or $7,000 if you’re age 50 or older). This number is the maximum so you can contribute any amount less than that, just no more than that.
Let’s say you’re 28 years old and make $55,000 a year. You decide to contribute $5,000 to your IRA. When you go to file your taxes, instead of being taxed on your full $55,000 salary, you’d only be taxed on $50,000. That money you would’ve paid in taxes went to your investment account instead. Now, there’s a catch. Unfortunately, you won’t be able to get off without paying taxes at all. The tax payment is deferred until you actually withdraw the money in retirement (after age 59½). It’s then taxed at whatever tax bracket you’re in during retirement.
Watchout
Who wants to pay $16,000 in taxes needlessly?! Not this guy. In this example, I used really simple math that didn’t account for growth and compounding. Keep reading to see how much money our 28 year old is much more likely have in retirement.
Are there different types of IRAs?
Yes, there are. Next question.
OK, there are two types of IRAs. There’s a traditional IRA and a Roth IRA. A traditional IRA works exactly as I described above. A Roth IRA differs in how you’re taxed. In a Roth IRA, instead of deferring the taxes until retirement, you contribute to the IRA with after-tax money (i.e. after you’ve already paid income tax). Then, when you go to withdraw the money in retirement, you don’t pay any taxes on the withdrawal, including any growth. So it’s a matter of whether you want to pay taxes on the front end (Roth IRA) or on the backend (traditional IRA). If you’re working with a tax advisor, they can help you understand which choice is better for you.
Some consider a Rollover IRA to be a third type. This is simply a traditional IRA that’s started by transferring funds from an employer sponsored plan, like a 401(k). More on IRA rollovers in another post.
Then there’s a SEP IRA, which is a type of IRA small business owners can set up as a retirement account for themselves and their employees. More on retirement savings options as an entrepreneur in another post.
Why should you invest in an IRA?
An IRA is not just a tax advantaged savings account. It’s best used as an investment account. This means that the money you contribute to the IRA can be used to buy equities (stocks, bonds, index funds, mutual funds, etc). When you invest the money into vehicles like this, you typically see some sort of return on your money. For instance, if you were to invest your money into a low-cost index fund that tracks the total stock market (like VTSAX for instance), you could potentially see a significant return on that investment. Now let’s put some numbers to that.
Above, we said our 28 year old was investing $5,000 a month for 32 years. That was $160,000. This assumes she was simply putting the money in her IRA and letting it sit there…like a no-interest savings account. Now, let’s say she instead invested that $5,000 into the market and got the average 7% per year return over that time. At age 60, she would have…wait for it…over $551,000! That’s the magic of compounding. I’ll go deep into compound interest in another post, but for now, just know to put your money in an investment for the best chance of growth.
What you do is what matters, not what you think or say or plan.
How to open an IRA?
Something to note. Even if you’re already participating in a 401(k) plan through your employer, you can still contribute separately to an IRA. In fact, you can even have multiple IRAs. The one thing to note with having multiple IRAs, though, is that the annual contribution limit is still the same. So in 2020, you can contribute up to $6,000 total across any IRAs you have, whether you have one or 5. For instance, if you have a traditional IRA and a Roth IRA and you want to max them out, a scenario might be that you contribute $4,000 to one and $2,000 to the other one. You just can’t exceed the $6,000 limit.
I have several IRAs. I have one through E*Trade, which is a rollover from a previous job’s 401(k), and I have two IRA’s through Fidelity. One is a rollover from another previous job and one is a separate one I set up. Again, the contribution limit across all of these is still $6,000.
You can technically open an account through any brokerage that offers IRAs, but I’ll talk specifically about the ones I have because that’s what I know.
Boom! You’re on your way to building wealth. Drop me a line with your thoughts.
