Anyone can save for retirement, not just those who have access to a 401(k) plan at work. An individual retirement arrangement, or IRA account, is a good way to build up a fund and get tax advantages at the same time. If you’re self-employed or otherwise don’t have a 401(k) option, an IRA can serve you well.
How IRAs work
There are two main types of IRAs — traditional and Roth IRAs — and they work a little differently. Although both rely on personal contributions and can be opened at banks and most brokerages, the tax treatment for each differs.
Traditional IRA: Like a 401(k), contributions are taxed when you withdraw the cash, and can reduce your taxable income in the year the money is earned. If you have no retirement plan at work, all contributions may be tax deductible up to certain limits, regardless of income bracket. If you take out any money before you turn 59½ years old, you may have to pay an additional 10% tax on that withdrawal along with regular income taxes.
Roth IRA: Contributions you deposit in a Roth IRA are posttax, meaning that the funds are put in after income taxes on the money have been paid. But once in the fund, any interest or investment returns earned by the cash are tax free once you reach retirement age. This option may be more appealing to younger workers who may pay a low tax rate now and want to avoid potentially higher rates on their income once they’re retired.
Have questions about Roths? See our complete Roth IRA guide.
What are the limitations?
As helpful as these accounts can be, there are some restrictions as to who can get them, how much can be deposited and how much is deductible.
To qualify for an IRA, you must receive taxable earnings from working in a given year. For traditional IRAs, you also cannot contribute if you are 70½ or older. Roth IRAs don’t have that age restriction, but above a certain income level, participants can’t make contributions.
For all contributions by most people, combining multiple IRAs if applicable, there are limits based on your age and can be other restrictions depending on your income. For 2015, in most cases you can put in no more than $5,500 to $6,500 if you’re over 50 — in traditional and Roth IRAs combined. Alternatively, if your taxable compensation is below that dollar limit, your compensation is your maximum.
What you put in a Roth IRA isn’t tax deductible, but for traditional IRA contributions, the tax treatment depends on whether you or your spouse participate in a retirement plan at work. If you do, then the deduction can be limited, but if not, generally the full amount of your contribution is deductible.
IRAs are useful tools that can help most when supplemented with other retirement funds. You can also consolidate, or roll, 401(k)s you had with previous employers into an IRA. Whatever you decide to do, IRAs are ultimately designed to keep you on track with your retirement goals.