11 Rules That Will Help You Better Understand Your IRA

IRA road sign

Though some workers neglect to save for retirement because they're unwilling to part with a portion of their earnings, for others, the decision not to save boils down to confusion and misinformation. In fact, though IRAs are one of the most convenient retirement savings tools out there, many folks don't open IRAs because they don't understand how they work. In a 2017 TIAA survey, 17% of Americans think IRAs are too complicated, which explains why only 31% of workers have one to begin with. Whether you've previously shied away from an IRA or have an account but are still feeling lost, here are some basic rules you no longer need to be confused about.

1. Traditional IRA contributions are tax-deductible

Though there are additional IRA types for self-employed individuals , most people who open an IRA choose between the traditional version and the Roth. If you opt for the former, then you'll get to deduct your contribution on your tax return, and your ultimate savings will be a function of your effective tax rate. So if, for example, you put $3,000 this year into a traditional IRA, and your effective tax rate is 25%, you'll get $750 in immediate tax savings.

2. Roth IRA contributions are made with after-tax dollars

Unlike traditional IRA contributions, Roth accounts are funded with after-tax dollars. What this really means is that you can't take a deduction the year you actually fund your Roth. So if you were to put $3,000 into a Roth this year, you'd get no tax break on your 2017 return.

3. Traditional IRA withdrawals are taxable

Once you fund your traditional IRA, your money gets to grow on a tax-deferred basis until the time comes to take withdrawals. This means that if your investments make money year after year, you won't be liable for taxes throughout your career. Once you retire and start taking distributions, however, your withdrawals will be taxed at your ordinary income tax rate.

4. Roth IRA withdrawals are tax-free

Though you don't get an up-front tax break for funding a Roth IRA, you will get to benefit from tax-free growth for as long as you hold your account. And when the time comes to take withdrawals, you'll get that money completely tax-free.

5. Early traditional IRA withdrawals are penalized

Because IRAs are designed to help you save for retirement, and because you get a tax break for funding a traditional account, you're required to keep that money locked away until age 59 1/2. If you take a withdrawal prior to reaching 59 1/2 and you don't qualify for an exception, you'll be subject to a 10% early withdrawal penalty on the amount you remove, plus taxes on that sum. (Keep in mind that you'll be taxed on your traditional IRA withdrawals no matter what, but you'll avoid the penalty by leaving that money alone until age 59 1/2.)

6. Early Roth IRA withdrawals can be penalty-free

Since you don't get an immediate tax break for funding a Roth IRA, you're allowed to access the money in your account at any time, and for any reason, without penalty, as long as you limit your withdrawals to your principal contributions only. Say you put $5,000 into a Roth at age 30 and that balance grows to $6,000 in two years' time. If, by age 32, you encounter a situation where you need that money, you can withdraw the initial $5,000 you put in without penalty. If you touch the $1,000 that represents the growth portion of your account, however, you'll take a hit.

7. Traditional IRAs impose required minimum distributions beginning at 70 1/2

You can't just leave your traditional IRA to sit and grow indefinitely. Once you turn 70 1/2, you'll be obligated to start taking what are known as required minimum distributions (RMDs), the exact amount of which will depend on your account balance and life expectancy at the time. If you fail to take your full RMD, you'll face a 50% penalty on whatever amount you neglect to withdraw. So if, for example, your RMD for the year is $4,000 and you don't take it, you'll lose $2,000 right off the bat.

8. Roth IRAs don't impose mandatory withdrawals

One major benefit of Roth IRAs is that they don't come with RMDs. This means that if you don't need to access your money right away in retirement, you can let it sit and continue to achieve tax-free growth. Not only that, but you can leave the money in your Roth IRA to your heirs, and once they inherit it, they'll be able to access that money tax-free.

9. Traditional IRAs have no income limits

Traditional IRAs don't come with associated income limits. You can earn millions of dollars a year and make tax-deductible contributions to a traditional IRA provided you don't have access to another retirement plan through your job (or your spouse doesn't either, if you're married). Now if you do have access to an employer-sponsored retirement plan, you can still fund a traditional IRA, but you won't get a tax break for contributing if your earnings are too high.

10. Higher earners can't contribute to Roth IRAs directly

While traditional IRAs don't impose income limits, if you're a high enough earner, you won't be eligible for a Roth IRA. The current income thresholds are $133,000 for single tax filers and $196,000 for joint filers. That said, if your earnings exceed these limits but you still wish to contribute to a Roth, you can put your money into a traditional IRA and convert it down the line. If you do, you'll pay taxes on the amount you convert, but your money will then enjoy the tax-free treatment Roth accounts offer.

11. The annual contribution limits for traditional and Roth IRAs are the same

Regardless of whether you open a traditional or Roth IRA, you'll be subject to the same annual contribution limits. Currently, workers under 50 can put up to $5,500 a year into either type of IRA. Workers 50 and older get a catch-up provision that raises this limit to $6,500. Even if you can't max out these limits, contributing any amount to your IRA will help you grow your retirement nest egg.

Though there are numerous rules associated with IRAs, once you start to read up on them, you'll hopefully come to find that they're not as confusing as you once thought. And from there, you'll be better positioned to make the most of your account and amass a sizable amount of savings that'll serve you well in retirement.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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