You hear a lot about the importance of saving for retirement, and an individual retirement account is a good way to help you achieve your goals. But how much do you really know about IRAs and how they work?
Here are a few misconceptions that might trip you up if you don't know the truth.
1. All IRAs are the same
With a traditional IRA, the money you contribute typically goes in tax-free, but once you reach retirement, your withdrawals are taxed as ordinary income.
Roth IRAs work the opposite way, in that contributions are made with after-tax dollars, but withdrawals can be made tax-free in retirement. The annual contribution limit for both traditional and Roth IRAs in 2017 is $5,500 if you're under 50, or $6,500 if you're 50 or older.
Not everyone can open a Roth IRA, though. If you earn more than $133,000 as a single tax filer this year, or more than $196,000 as a married couple filing jointly, you won't be eligible to contribute to a Roth.
Then there's the SEP IRA, which is an option if you're self-employed or run a small business. The money you contribute to a SEP IRA goes in pre-tax; withdrawals are taxed in retirement, but the annual limit is much higher than that of a traditional IRA. For 2017, you can contribute up to a quarter of your income, for a maximum of $54,000.
There's also the SIMPLE IRA, which is another tool geared toward small-business owners and the self-employed. SIMPLE IRA contributions go in tax-free and are taxed upon withdrawal. But like SEP IRAs, SIMPLE IRAs allow savers to sock away more money each year for retirement. For 2017, the annual contribution limit is $12,500 if you're under 50. If you're 50 or older, you can put in up to $15,500. Employers are also required to match employee contributions to a certain degree, so if you work for a small business that offers a SIMPLE IRA, you'll get some extra money on top of what you put in. If you're self-employed and open a SIMPLE IRA, you'll get to contribute as both employer and employee.
2. You can leave your money in an IRA for as long as you like
Contrary to what you may have been led to believe, you can't just let your money sit in your IRA indefinitely. Unless you have a Roth IRA, you're required to start taking minimal distributions once you turn 70 1/2. This applies even if you're still working at that time. The exact amount you'll need to withdraw will depend on how much you have in your IRA, coupled with your life expectancy.
The downside of required minimum distributions is that they automatically increase your tax burden, since IRA withdrawals are subject to ordinary income taxes.
If you're still working by age 70 1/2 and are earning a good salary, that additional mandatory income could propel you into an even higher tax bracket. But if you don't take your required minimum withdrawal, you'll face an even greater consequence -- a 50% penalty on whatever amount you fail to remove from your account.
3. You can only use your IRA money for retirement
Because IRAs are designed as a retirement savings tool, you'll typically face a 10% early withdrawal penalty if you remove money from your account before reaching age 59 1/2. (Note that this penalty only applies to IRAs where contributions are made with pre-tax dollars. With a Roth IRA, you can withdraw your principal contributions for any reason at any time.)
However, there are certain situations where you can take money out of an IRA early without being penalized.
If you're buying a home for the first time, you can withdraw up to $10,000 from your IRA to pay for it. In fact, if you're married and you and your spouse each have an IRA, you can each withdraw $10,000 for a combined total of $20,000. You can also take an early penalty-free withdrawal to cover higher-education costs for yourself, a spouse, or a child.
That said, be aware that any time you make an early withdrawal from your IRA, that's money you won't have available in retirement. And you won't just be losing out on the principal amount withdrawn; you'll also be losing out on whatever growth that money could've achieved over time.
Imagine you withdraw $10,000 at age 35 to help buy a home. That $10,000 could turn into $100,000 over 30 years if it's invested at an average annual return of 8% (which is attainable with a stock-focused portfolio). That's why in most situations, you're better off leaving your IRA alone and finding other ways to finance your more immediate goals.
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Now that you've got the lowdown on IRAs and how they work, it's time to explore your options for opening one. And remember, the sooner you do, the more opportunity you'll have to amass a sizable nest egg in time for retirement.