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What Are IRAs and Why Do I Need One?

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If you’ve been hearing IRA-this and IRA-that but never got around to learning what it was and why it rocks, it’s high time to learn how an IRA can help you retire like a rich lady. Or rich gentleman, since fun fact, gender identity has nothing to do with who’s allowed to open an IRA.

IRAs are another tax-advantaged retirement account, designed and developed to help people save more money for retirement. If you don’t have a pension and your employer doesn’t offer a 401(k), these are the retirement solutions you’re looking for (no droids here though).

What is an IRA?

IRA stands for “individual retirement account” – simple, right?

IRAs were created by the IRS (that means Internal Revenue Service, to you)  to help people save for retirement by offering tax breaks in exchange for you saving your money until you’re old af. In most cases, that means 59 and a half.

Yes, the IRS is your five-year-old cousin who measures half-birthdays. I think it’s weird, too.

But there are different kinds of IRAs, right?

That’s right! See, I knew you knew more about IRAs than you were letting on.

You’ve probably heard about both traditional IRAs and Roth IRAs, which are the two most commonly applicable and accessible accounts. There are varieties of IRAs that are specific to people who are self-employed, but for most of us, we’re going to be choosing between a traditional or Roth IRA.

What do traditional and Roth IRAs have in common?

If you’re under 50, you can only contribute $5,500 a year to a Roth IRA or a traditional IRA. Once you hit 50, you can contribute an extra $1,000 a year, since the government wants to make extra sure you’re not going to have to eat cat food in retirement.

What’s the big difference?

There’s a key difference between traditional and Roth IRAs, and in the news that will surprise no one, it’s taxes. Because isn’t it always taxes? The two account types are taxed very differently, although, in both situations, you’re getting tax benefits.

With a traditional IRA, your contributions to the account are made with pre-tax dollars. Sometimes that means it comes off of your paycheck before taxes are applied, and other times it means you’re in line for a sweet refund when you file your taxes. However, it’s not tax-free. When you withdraw from a traditional IRA in retirement, you’ll pay taxes on your money then.

With a Roth IRA, you contribute after-tax dollars, so you’re not in line for any kind of tax break this year. Instead, you won’t owe any taxes on your money when you withdraw it in retirement, so what you withdraw will be what you actually get to keep and spend – no need to put a chunk of it aside to pay taxes.

When should I choose a traditional IRA?

A traditional IRA makes sense if you have a high income since there are no limits other than the amount you can contribute. Plus, if you’re making a ton of money, you’re probably in a high tax bracket and can reap some sweet tax savings by contributing.

When should I choose a Roth IRA?

Roth IRAs come with income limits, so you can only make full use of them if you make under $198,000 as an individual or $125,000 as a couple. So if you’re like, “Well yeah, I’m young, of course, I make less than that,” a Roth IRA is a great fit for you. You’ll be able to contribute the full $5,500 every year, and have it grow tax-free (and withdraw it tax-free when you’re old!)

One big note: the IRA itself isn’t an investment

With all of this talk about long-term growth, you’d be forgiven if you thought that all you had to do was put money in an IRA, sit back, and watch your money grow. Sadly, it’s a bit more complicated than that.

Any type of IRA is just an account, and it’s what you keep in that account that helps your money grow. You can use an IRA to hold just about any kind of investment, and almost every online brokerage and robo-advisor will let you open an IRA with them.

One of the big tax perks you’ll get when it comes to those investments is that all of your investment income – that is, the growth on your stocks, bonds, mutual funds, ETFs, etc. – is tax-free. If you had that same growth outside of an IRA, you’d need to report it on your taxes, and hand a chunk of it back to the IRS. Gross.

So… can I use one?

Short answer: yes!

Which type of IRA is best for you will depend on the factors we covered, and a few others if your situation is really complex, but if your income is under six figures, and you don’t want the money locked in until you’re 59 (and a half) then a Roth IRA is a safe bet, and you should get one.

To make the investing process easy as pie if you’re new here, check out robo-advisors, and if you’re a bit more advanced, online brokerages might be another good option to turn your cash into a solid retirement plan.

Such adulting over here, I know.

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