Understanding an individual retirement account (IRA) and how it works is a must for retirement savers. An IRA comes in two different varieties: the pre-tax and the post-tax. It also may or may not be connected to your employment. Below are some of the commonly misunderstood facts about investing in IRAs.
1. An IRA isn’t an investment in itself; rather, it holds investments
When people say they invested in IRA, it implies that the investment is held in an IRA. In other words, an IRA isn’t an investment; instead, it’s merely a type of account with a name that’s reflective of its tax treatment. This will provide a better grasp of your retirement investment and prevent you from being misled by salespeople that may claim the IRA is an investment type.
Depending on the types of investments within your IRA, it may outperform or underperform someone else’s IRA over time, even if both investments are held in the same financial institution. To avoid any confusion, it’s essential to maintain consistent language when referring to these investment types.
2. All IRAs are not the same
There are several types of IRAs out there. Traditional IRAs are not the same as Roth IRAs since they have different tax treatments. Traditional IRAs are generally pre-taxed (meaning they contain money that hasn’t been taxed). It can also include money rolled over from 401(k) plans from previous employers, which works because the tax treatment for both accounts is the same.
Roth IRAs, however, are post-taxed (meaning they contain money that has been taxed). Once you invest money into a Roth account, you won’t pay tax on investment growth, dividends, or lump sum withdrawals. When you invest in a Roth IRA, you agree to pay tax at today’s rate in exchange for never having to pay tax for the money in the future. A Roth IRA can be a powerful savings vehicle, especially if you expect tax increases in the future.
3. You can still invest in an IRA beyond a specific year
Once the clock ticks 12:00 a.m. on 31 December, you may think you have missed the opportunity to contribute to your IRA account for that year. But that’s not the case, as you can still make IRA contributions for the previous year up until April 15th the following year. For instance, if you have extra cash in January 2021 and haven’t maxed out your contribution for 2020, you can still save to your IRA until April 15, 2021.
While you have so much time to make your contributions, it’s always advisable to make it as early as possible. The logic here is that the earlier you make your contributions, the more time you’ll have to start compounding in the tax-advantage space. The best practice is to deposit the money to your account in January and make it a yearly routine.
4. RMDs start at age 72
RMD (required minimum distribution) is the mandatory withdrawal investors have to make from traditional IRA accounts once they turn 72 years of age. The essence of the required minimum distribution is simply because the IRS wants to ensure it collects the tax revenue that accrues to the account when you make withdrawals.
By labeling a stiff 50% penalty if you fail to withdraw the RMD, the IRS ensures you pay the specified tax on your traditional IRA each year.
Roth IRAs, on the other hand, don’t have RMDs. There’s no obligation to withdraw. So you can hold on to withdrawals from your account for as long as you wish and even pass it to your heirs without any tax consequences. This also highlights an advantage of investing in a Roth IRA over a traditional IRA.