An IRA is an Individual Retirement Account. It’s similar to a 401K, except that you can get one even if your employer doesn’t offer it. This is particularly great if you’re self-employed or a small business owner!
But, even if you have a 401(K), you can still get an IRA. And we’ll discuss later whether or not that’s a good idea, but much of that depends on the type of IRA you can – or want to – open.
In 2020 the types of IRAs available are:
- Traditional IRA
- Roth IRA
- SEP IRA
- Simple IRA
And, again, we’ll cover those later too. But in the meantime, what exactly is an IRA, how does it work, and does it make sense for you to open one?
How Does An IRA Work?
IRAs, like 401(K)s, are savings accounts for retirement. Unlike 401(k)s, your money goes in after it’s been taxed, as opposed to before. This means that, also unlike 401(K)s, the money you take out will be tax-free.
Additionally, the investments held in your IRA can encompass a range of options including stocks, bonds, ETFs, and mutual funds. 401(K)s are considerably less diverse than IRAs, which is one of the main benefits this type of account has.
The money you put into your IRA will gain interest – like it would in a bank – but unlike a bank, the interest you receive is generally not as structured. In fact, like most investment portfolios, there’s a risk you could lose money. But this is also true for 401(K)s.
The money you contribute can only come from earned income that meets the IRA rules. Income from investments, Social Security benefits, or child support does not count as “earned income” because you didn’t directly do anything to “earn” it.
Because IRAs are meant for retirement savings, there’s usually an early withdrawal penalty of 10% if you take the money out before age 59 1/2. Depending on what type of IRA are you have you may also need to pay income tax on early withdrawal.
Withdrawl & Distribution
If you have a aren’t taking distributions from your Traditional, SEP, or SIMPLE IRA by 72 (70 ½ if you reach 70 ½ before January 1, 2020), you’ll need to take RMDs.
RMDs (required minimum distribution) is a law that – in simple terms – makes you take payments from your IRA that would clear out your account in the next 10 years. By the time you’re 82 (or 80 1/2) your IRA account would, theoretically, run out.
Roth IRAs, on the other hand, do not require RMDs or withdrawals of any kind until after the account holder’s death where it would have to be distributed to whatever beneficiary is listed.
RMDs are a complex financial matter with a good deal of jargon, but if you’re interested, here are the regulations on RMDs from the IRS.
But what if you’re not retiring or anywhere near 72? Can you get a loan?
Unlike a 401(K) where you can take loans from your account, you generally can’t take loans from Traditional or Roth unless it’s:
- To cover a first-time home purchase (up to $10,000)
- For qualified higher education expenses (in line with tax laws)
- If you become permanently disabled (in line with tax laws)
- For the birth or adoption of a child (up to $5,000)
EXCEPT, of course, that it’s 2020. Accordingly, under the new CARES Act, you can take a distribution from those accounts for other reasons if you were impacted by COVID. But, I warn you: it’s by no means a straight-forward, fast, or easy undertaking.
And, of course, exactly what sort of penalties you might face, how much you can borrow, and when you can borrow it depends entirely on the type of account you have. Which brings us to our next point…
Types Of IRAs
As of 2020, there are four types of IRAs. Traditional and Roth accounts can be opened by individual taxpayers, but SIMPLE and SEP can only be opened by small business owners or those who are self-employed.
- Tax-deductible contributions
- Tax-deferred growth
- No income limits** AGI limits apply if you or your spouse have another retirement plan
- Distributions can be taxed
- Low contribution limits
- Limited investment options
- No age limit to contributions
- No retirement plan restrictions: which means you can have a 401(K) or similar
- In most cases, there are no taxes on your beneficiaries’ RMDs either
- Contributions are never tax-deductible
- IRS set income limits (you can see them and do the calculations here, but it’s a bit intense)
- Potentially high contribution limits (up to $57,000)
- Contributions are deductible – includes contributions to employee accounts
- Flexible contributions (no need to contribute every year)
- No catch-up contributions
- Required proportional contributions for each eligible employee if you contribute for yourself
- RMDs at 72
- Tax-deductible, including contributions to employee’s accounts
- Plenty of investment options (but depends on the institution that holds the account)
- Available to larger companies than SEP (up to 100 employees)
- Mandatory employer contribution
- Lower contribution limit
- No loans allowed
- Can’t offer any other employer-based retirement plan
- Truth be told, you’re probably better off setting up a 401(K) plan if you qualify for SIMPLE but not SEP plans
Should I Get An IRA If I Have A 401(k)?
In some cases, this makes sense. But we can’t say definitively whether this makes sense for you personally because these things are too nuanced for a virtual armchair diagnosis.
In most cases, however, having an IRA with a 401(K) offers you the most diverse investment portfolio and is, in theory, the easiest way to safeguard your money from potential market crashes.
But if your employer matches, an IRA might be particularly attractive. If you can contribute enough to your 401(K) to max out your employer’s maximum match, then you can toss whatever money’s left into an IRA to diversify your portfolio while still saving.
For example, say you – personally – can contribute $5,000 per year, but your employer will only match your contributions up to $4,000 per year (for a total of $8,000 between the two of you.) You can save $8,000 a year in your 401(K) while throwing the spare $1,000 – that your employer wouldn’t match – into an IRA.
Giving you a total of $9,000.
Granted, this is exactly what you would’ve had if you only had a 401(K), but that extra $1,000 can go towards different investment options that aren’t available to 401(K)s. Investments like mutual funds, ETFs, and stocks.
How Do I Open An IRA?
If you’re not a small business owner or self-employed, you can grab a Traditional or Roth, but if you are self-employed or a small business owner, you can open a SEP or a SIMPLE. In the case of SIMPLE, however, you’re probably better off opening a 401(K) as we discussed earlier.
At any rate, you can choose to manage Traditional and Roth accounts yourself or if you want someone to do it for you so you can be hands-off.
In the case of the DIY investor, you’ll want to look for online brokers. If you want something a bit less involved, you can opt for a human financial advisor (and pay decent money for their time) or opt for a robo-advisor, which is exactly what it sounds like.
Once you decide what path you want to take, you can start looking for brokers. Which is – very much – like loan shopping. But, unlikely loan shopping, you’re not going to regret putting $50,000 into this account.