The IRA aka Individual Retirement Account
What is it and how is it different than a 401k?
*If you haven’t read my 401k post you should read that first – link here!*
Like the 401k, the IRA is a retirement account that provides special tax benefits. One big difference is that the IRA is a retirement vehicle that is controlled by the individual rather than a company. Therefore, the individual has much greater control over his/her IRA and can make decisions such as which IRA provider to pick, which funds to invest in, and which type of IRA to choose (which I discuss in more detail below).
When can you start contributing to an IRA?
The beauty of the IRA is that generally, anyone with U.S. taxable income (including salary, wages, commissions, and bonuses) can start contributing to an IRA account. And yes, you can be a student who works part-time and start an IRA. Non-U.S. citizens are also able to open an IRA account but the question of whether it’s a good idea depends on how their home country recognizes IRAs.
For 2018, the maximum contribution limit for an IRA is the lesser of your taxable income or $5,500/year, which is much lower than the 401k contribution limit of $18,500. If you are 50 years of age or older, you are allowed to contribute an extra $1,000/year. The IRS just recently announced that starting 2019, the contribution limit will increase to the lesser of your taxable income or $6,000/year.
Example of someone ineligible to max out:
If you only made a taxable income of $2,000 one year, you will only be able to contribute up to a maximum of $2,000, even if you have enough funds to max out your IRA. Note: taxable income is gross income, or income you make before taxes are taken out.
Unlike the 401k, you have a longer contribution timeline for your IRA. Usually the deadline to make your IRA contributions is sometime around Mid-April of next year. For example, the deadline to make 2018 IRA contributions is 4/15/2019 (the IRS changes the deadline by a few days each year so make sure to verify the date every year on the IRS website). So, unlike the 401k, you have a little over 16 months to max out your IRA! Also, IRA contributions aren’t automatically deducted from your paychecks like 401k contributions are. You can do one large lump sum deposit into your IRA at the beginning of the year, random one-off deposits, or have automatic deposits set up from your bank account – the choice is yours!
Benefits of IRA
Like the 401k there is the Traditional IRA and the Roth IRA both provide tax benefits. Quick overview: Traditional gives you tax benefits now, while Roth gives you tax benefits in the future (read the Special Tax Benefits section of the 401k post for examples and more details). The great thing is that if you’re eligible, you can easily pick which type of IRA you want to contribute to – you don’t have to hope that your company offers both types. In fact, if you really want to, you can actually have both a Roth and a Traditional IRA if you qualify (more on that later). If you want to contribute to both in one year just make sure that the total contribution is not more than $5,500 – unfortunately you cannot contribute $5,500 to both accounts. Also, if your spouse doesn’t make any income you’re able to make a contribution on their behalf! It would have to be made to a separate account under your spouse’s name (sorry you can’t double up on your IRA account) and you have to make at least as much as you contribute for you and your spouse. For example, if you only made $7,500 you could only only contribute up to $7,500 cumulatively for you and your spouse even though the cumulative IRA max for a married couple is $11,000 for 2018 (or $5,500/person).
But Wait, There's more!
IRAs have extra special benefits 401ks don’t have, which allow you to avoid the 10% penalty fee for withdrawing money from your IRA early (before 59.5 years old).
- Roth IRA contributions can be withdrawn penalty-free and tax-free at any time. Wait whaaat… yeah that’s right! Important thing to note is that this is only the case for ROTH IRAs (not Traditional) and that it’s only for contributions (i.e., the money you deposit into your IRA).
- If you contributed $5,000 to your Roth IRA today and a few years later it grew to $6,500 you can only withdraw up to the $5,000 you originally contributed penalty free – the $1,500 of returns ($6,500 – $5,000) is not eligible for penalty free withdrawal.
- Burden of proof: You may have to provide proof to the IRS that you actually contributed whatever amount you withdraw. The best way to track contributions is by keeping a record of every 5498 form your IRA provider sends you (it’s sent out once a year).
- Even though you can, it doesn’t mean you should. Remember, taking money out means that it’s no longer invested and making money for your eventual retirement, so only in dire situations do I recommend taking money out of your IRA.
- First time home buying. You can withdraw up to a lifetime limit of $10,000 from your IRA to go towards purchasing, building, or rebuilding your first home. *The lifetime limit is just for first time home buying. Remember, you can withdraw your contributions at any time*. Things to note:
- You will not be hit with the 10% penalty for withdrawing early but you will have to pay taxes if you withdraw from a Traditional IRA
- You have 120 days from when you withdraw the money to use it on qualified expenses (which the IRS states as the “costs of buying, building, or rebuilding a home” and “any usual or reasonable settlement , financing, or other closing costs”)
- Must be used for your primary residence
- If you’re married and both of you are first time home-buyers, each of you can receive $10,000 for a first home
- For more exceptions read Publication 590-B [scroll to page 24 and look for the Exceptions section]. Other exceptions include: disability, qualified higher education expenses, annuity, certain medical expenses, etc.).
Depending on your income you may be ineligible from contributing to the Roth IRA and/or receiving full tax benefits from the Traditional IRA. Alright, it might get a little bit complicated so please bear with me and re-read a few times if necessary!
For those who make ≤ $63,000/year gross income:
As of 2018, if you’re making ≤ $63,000/year you are able to contribute to both a Traditional and/or Roth IRA and take advantage of the full tax benefits.
Overview of MAGI
MAGI, also known as modified adjusted gross income, determines whether you can contribute to certain types of IRA and/or if you qualify for full tax deductions.
How to Calculate your MAGI: First, figure out your adjusted gross income, or AGI, by adding up all your income and then subtracting out tax-deductible expenses (tax- deductible expenses = expenses that can be subtracted from your taxable income) such as: educator expenses, health savings account (HSA) contributions, student loan interest, IRA deductions and paid alimony. You have to calculate AGI for your taxes anyway, so see line 37 of the 1040 tax return form for a more detailed list of income and eligible deductions: link here for 2018 form. For most people, their AGI and MAGI is very similar or the same. You modify your AGI by adding back in, such as with the following: any deductions you took for IRA deductions (only applies if you contributed to a Traditional IRA), any deductions made for student loan interest/tuition, any excludable savings bond interest, any previously excluded foreign earned income, etc. (Read the Modified Gross Income section of this IRS publication for more details). Once you calculate your MAGI you use it to figure out what type of IRA you’re eligible for and if you decide on contributing to a Traditional IRA, if you qualify for the full tax deduction. For example, if your tax status is Single and your MAGI is greater than $135,000 than you are not able to contribute to a Roth IRA – more in depth examples below!
Traditional IRA Requirements
No Contribution Limit, but variable tax deduction limits:
- While people of every income level are able to fully contribute to a Traditional IRA, you may be capped on your tax deductions depending on your filing status, MAGI, and if you/your spouse is covered by a retirement plan at work. Tax deductions are great because in the eyes of the IRS it’s as if you made less money than you actually did. For example, if your gross income for 2018 was $50,000 but you contributed $5,000 to a Traditional IRA the IRS taxes you as if you only made $45,000.
- If you’re married, you determine deduction limits individually. This means that depending on your work retirement situation, you and your spouse may have different income deduction ranges (see tables below):
- Full deduction: You receive a tax deduction equal to the amount you contributed.
- Partial Deduction: You receive a tax deduction equal to a portion of what you contributed. Use this calculator (for 2018) to help you determine your partial deduction. If you want to know how the phase out works, read the Example Worksheet for reduced IRA Deduction section of the IRS publication.
- No Deduction: While you can contribute up to the maximum amount, you will not be able to take any tax deductions.
Chart for those who are covered by a retirement plan at work (2018):
Chart for those who are not covered by a retirement plan at work (2018):
Roth IRA Requirements
No tax deduction, but variable contribution limits
- You do not receive any tax deductions the year you contribute but your future withdrawals (after hitting 59.5+ years old) are 100% tax free.
- Unlike the Traditional IRA, if you fall within certain MAGI ranges, you will not be able to contribute to a Roth IRA or be limited in how much you can contribute:
- Full contribution: You are able to contribute the full IRA limit, which is $5,500 for 2018 and $6,000 for 2019.
- Partial contribution: You are able to contribute a partial amount (i.e. you can contribute up to the maximum limit), depending on your MAGI. You can use this calculator (for 2018) to figure out up to how much you can contribute. If you want to know the exact calculation read the “Amount of your reduced Roth IRA contribution” section of this IRS page.
- Zero contribution: You’re not able to contribute to a Roth IRA, unless it’s through a backdoor Roth (which I won’t be talking about in this post – sorry! But I would highly encourage you to do your own research on it!)
Roth IRA contribution Chart (2018)
Traditional Or roth ira?
If you read my 401k post, I wrote that generally, if you’re in a lower tax bracket (15% and lower) you should opt for the Roth; otherwise, you should consider going for the Traditional. While I still stand by the Roth option for those who are under the 15% tax bracket, I’m conflicted for those above that tax bracket who qualify for both the Traditional and Roth IRA. Why? Well, the biggest reason is because the Roth IRA is so flexible compared to other retirement accounts. I mean, you’re able to withdraw your contributions at any time, penalty-free. You shouldn’t plan on withdrawing from your IRA until retirement, but if there were some big emergency, it’d be nice to know that you have your Roth IRA contributions in your back pocket. At the same time, if you’re able to take the full tax deduction and you’re in the 22% tax bracket, you’d be saving $1,210 in taxes ($5,500 * 22%) which you can use to invest in other places. Think about your specific situation and possible future situation to figure out what type of IRA makes the most sense for you. If you’re a college student, working part-time and not making too much a year, you should most likely open a Roth IRA. If you’re income puts you above the Traditional IRA tax deduction band but below the Roth IRA contribution band, you should contribute to a Roth IRA.
What IRA Providers Can I Choose From?
There are a number of providers you can choose from but the 3 highly regarded companies are: Vanguard, Fidelity, and Charles Schwab. These companies are known to have some of the best and most affordable funds. If your company uses a 401k provider other than the 3 mentioned above, I highly recommend looking into Vanguard, Fidelity and Charles Schwab. I use Vanguard for my IRA and have really liked it so far, but will admit their interface isn’t the best.
What Should I Invest in
Low-cost Index funds! Not all 401ks are created equally, some are much better than others, but what you should do is look for diversified, low cost index funds. Index funds are exactly what they sound like, funds that just aim to track to an index – think S&P 500. They allow you to be invested in hundreds or even thousands of companies so that not all your eggs are in one basket. Also, because index funds aren’t looking to “beat the market” they require minimal upkeep and therefore have a much lower expense ratio (aka the annual fee that funds charge). Index funds typically have an expense ratio of .25% (although there are some as low as .04%) or lower while actively managed funds (funds that are trying to actively “beat the market”) can charge you more than 1% of your assets. While 1% doesn’t seem like a crazy high amount, over a few decades this can amount to hundreds of thousands of dollars. (Link to article showing cost differences)
How much you allocate to stocks vs bonds depend on a number of factors such as your risk tolerance and age. Generally, people recommend a 90/10 stocks/bond ratio for younger folks (people in their 20s and 30s) and as you age slowly lean more towards bonds.
Target Date Funds - For the lazy
If you just want a set-it-and-forget-it fund look into low-cost Target date funds. These funds typically ask you how old you are or when you’d like to retire by and automatically adjusts your allocations as you get older. Typically, the closer your target retirement date is, the less aggressive your allocations are. Like many products, not all Target date funds are equal so make sure to be aware of the expense ratio fees before choosing one (a reasonable fee is .25% or less).
- Domestic Stock Exposure: VTI or VSTAX (or something similar to these accounts –researching can be as simple as Googling the funds your company offers)
- International Stock Exposure: VGTSX or VTIAX
- Bond Exposure: BND
*You can Google the equivalent funds from above for whichever provider you have.
How do i time the market?
You don’t. No one knows with certainty what will happen in the market. “Experts” spend all day trying to find clever ways to “beat the market” but only about 1 out of 20 do (Link to article). It’s better not to make investment decisions off of feelings or you can very much end up buying high and selling low. So rather than spending time and effort trying to time/beat the market work to invest early and ride it out for the long-term (I’m talking a few decades here people). DON’T make hasty decisions such as cashing out your 401k during a sharp downturn – keep calm and hold on.
Unsatisfied with my answer? I recommend reading the theoretical story of Bob – the world’s worst market timer who only accidentally only invests during market peaks, but continues to invest during market downturns. TL;DR: After investing $184K over the course of 43 years and 4 huge market crashes Bob ends up with $1.1 MM. If he didn’t try to time the market and invested his money evenly instead of market peaks he would’ve ended up with ~$2.3 MM.(Link to full article)
How to Open an IRA in Under 15 Minutes
How to Open an IRA in Under 15 Minutes:
- Decision #1: What IRA provider are you going with? I recommend one of these 3: Vanguard, Fidelity, or Charles Schwab. If your 401k provider is already one of these 3 providers then I would just go with the same IRA provider as it’s convenient.
- Decision #2: Roth IRA or Traditional IRA? Read the “Traditional or Roth IRA?” section here and the eligibility requirements here.
- Gather the necessary information:
- Personal information (e.g. social security, date of birth, contact info, etc.)
- Employer Details (name of employer and address)
- Routing and account information of the bank account that will fund your IRA
- Complete the IRA provider’s online application. Here are the IRA links to the 3 providers I recommend: Vanguard, Fidelity, and Charles Schwab.
- Wait for confirmation from IRA provider – should take a few days.
- Once funded, start investing! Read the “What Should I Invest In” section from my 401k post as it applies to IRA investing.
- You’re done! Steps 1-4 should take you maybe 15 minutes to complete! Even if you don’t plan on contributing right now, you can still make an account and contribute later.
That’s it folks! If you got this far, I tip my imaginary cap to you – it was a lot to digest! Hopefully you found this post helpful and for those who have yet to start an IRA, I hope it inspired you think about opening one! As a reminder, I am not a professional financial advisor. I started this blog to help people better understand the basics of personal finance as I think it’s incredibly important. If you have any feedback or commentary, let me know!