Asset Strategy

What Is an Individual Retirement Account, an IRA?

Gold Alliance disclaimer


Talk to a representative

There’s no doubt that one of the most important financial goals every single person should have is to build a sizable retirement savings “nest egg.” This form of preparation for retirement through financial planning is imperative for every young adult (especially after graduating college), but, as a person reaches 30, 40, or more, it becomes even more important.

With the goal of building retirement savings in mind, the bigger question becomes this: What retirement plan is better—an IRA or a 401(k)? The fact is both options have their merits and downsides, so a better understanding of how an IRA and a 401(k) work is important. Knowing these differences and what distinguishes various IRAs will make it easier to choose which is your best option.

What is an Individual Retirement Account (IRA)

Created by the US Federal Government, an IRA is considered to be one of the more popular options available to put away money for retirement. An IRA allows the holder of the account to put funds aside while they’re working, including up to $5,000 per year for individuals under 50 years of age and up to $6,000 per year for those 50 and over, all of which are pre-tax dollars.
An IRA comes in two flavors: the so-called traditional IRA and the Roth IRA. Let’s start by taking a closer look at the traditional IRA.

Benefits of a traditional IRA

One of the biggest benefits of a traditional IRA is that the money put towards it is tax-deductible, meaning you can take a tax deduction on your federal income taxes based on how much you contributed to your traditional IRA that year. Another big benefit is that the money in your traditional IRA is tax-deferred, which means that, until you withdraw those funds, they can grow tax-free. (Financial experts agree that withdrawal should, best-case scenario, be made after you reach full retirement age.)

Of course, as with any good thing, there are downsides. For example, you’ll be limited on how much you’ll be able to deduct every year on your taxes based on your AGI (adjusted gross income). That means, in some instances, you won’t be able to deduct the full amount of what you put in your traditional IRA that year. There’s also the fact that, if you withdraw any funds before the age of 59 and a half, you’ll be hit with a 10% penalty (although some exceptions do exist). Lastly, after the age of 70 and a half, there are required minimum distributions (RMDs), which means that the government forces you to take yearly installments out of your retirement account and pay your taxes on them at that time.

Benefits of a Roth IRA

Another excellent vehicle for building a hefty retirement nest-egg is creating a Roth IRA with “after-tax” money. A Roth IRA will grow tax-free for as long as you’re funding it, and when you withdraw your hard-earned money, you don’t pay a penny on taxes. A Roth IRA also doesn’t have RMDs, which allows an individual to let their money sit and grow past the age of 70 and a half.

Roth IRAs do have a number of disadvantages, however, including AGI restrictions. An individual who files for over $120,000, or a couple who file over $177,000, isn’t allowed to contribute to a Roth IRA at all, and, as with a traditional IRA, there’s a 10% fee on early withdrawals under the age of 59 and a half. Also, Roth IRA funds must be left in the IRA for a minimum of five years or be subject to the same 10% fee.

Benefits of a 401(k)

If you’re lucky enough to work for a company that offers a 401(k) retirement plan, here’s a bit of advice: take full advantage of it as long as you can. A 401(k) comes with many excellent benefits, like higher contribution limits (up to $18,000 per year in 2017) plus income tax deduction during the pay year (which can be very helpful come tax time). Even better, there are no capital gains assessed until you withdraw your money. Also, withdrawals can be made in times of crisis without early-withdrawal fees, and, in some cases, your employer may offer to match your contributions, which is essentially giving you free money.

Like most retirement plans, however, 401(k) plans aren’t perfect. They have limited flexibility and options, and any income you make with them is taxable upon withdrawal. Also, at the age of 70 and a half, RMDs must be made—a fact that can result in an elevated taxation rate come tax time. Also, some employers make new hires wait six months or longer before allowing them to set up a 401(k). Since you can set up an IRA anytime you wish, if you work for an employer that offers one, you may consider to set up an IRA immediately and then open an additional 401(k) when you are allowed to do so.

Which plan is the best for you?

Choosing between an IRA or a 401(k) isn’t always easy. Your best option is to look closely at your retirement goals, your age, your income, and whether you work for someone or work for yourself. And a little bit of expert advice never hurts either. One thing is certain, however: choosing and using one of these excellent retirement savings options is a must.