We all dream of retirement—being able to live a comfortable lifestyle once we stop working a 9-5. Retirement looks different for each person, which is why understanding IRAs is so essential. Your IRA is the vehicle to take you to the future you want.

If you’re employed and your employer offers an employer-sponsored qualified retirement plan (usually a 401(k)), consider yourself lucky. For those who don’t have the luxury of an employer-sponsored plan, or don’t work the typical corporate gig, don’t worry! There are additional retirement account options available as well. IRAs offer a retirement savings option for everyone.

Of course, we all want to live comfortably when we’re in our retirement years, but many of us are plagued by the fear that our savings won’t be enough. Compounding this fear is the probability that social security won’t be around by the time you’re ready to retire. These fears are valid, so it’s important you gain an understanding of IRAs and your other retirement options now. It’s up to you to protect your future.

Are you unsure about what kind of retirement plan you have? Check out 7 Retirement Plans Explained & What You Need to Know to help you make sense of it. If you’d like a better understanding of IRAs, please read on—the following questions will help you figure out your IRA once and for all!

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1.     What is an IRA in the First Place?

To understand what an Individual Retirement Arrangement (IRA) is, let me explain it in the simplest way possible: an IRA is an account that enables you to save money for retirement. Contributions are tax-deductible and earnings grow tax-deferred.

I sometimes think that the “money experts” try to intimidate those who don’t do “the-investing-thing” in their everyday life. This complex approach paralyzes the general population, who ultimately end up doing nothing at all. I genuinely believe educating people about the concepts of investing not only benefits them, but those around them as well. Financial literacy is the key to a secure future.

So, most everyone has heard the term “IRA” used by financial experts. The term simply means “Individual Retirement Arrangement.” What’s important to understand about IRA’s is that there are different types  of IRAs (I will explain shortly). 

Anyone  who is receiving wages, salaries, commissions, and professional fees can establish an IRA. What’s great about an IRA is that even if you’re participating in your employer-sponsored qualified retirement plan, you can still establish an IRA on your own. This allows you to save even more for retirement. It’s important to note—there are  some restrictions (that I’ll go over as well).

“Retirement is not in my vocabulary. They aren’t going to get rid of me that way.” — Betty White

2.     What are the IRA Contribution Limits & Restrictions?

According to the IRS Contribution Limits for 2020, your total contributions to all your Traditional IRAs and Roth IRAs can’t exceed $6,000, or your taxable compensation for the year, if your compensation was less than  this dollar limit. The additional $1,000 you can contribute is in the event you’re age 50 and older (as is the case with yours truly) and is called a “catch-up” contribution.

It’s also important to note that the IRS is diligent, so if you contribute more than the allowable amount, they’ll nail you with a penalty of 6% on the amount you went over on your contribution.

A contribution made into a Traditional IRA (or, really, any IRA) account must be made in cash, but you can invest in almost anything you want. Once you’ve made your contribution, you can allocate the funds toward stocks, mutual funds, bonds, annuities, U.S. gold, and silver coins.

How do you know what you’re invested in (assuming you’ve already set up an IRA but would like to better understand how you’ve allocated the funds)? To give you an example, if you invested in mutual funds under the umbrella of your IRA,  the titling of your IRA account would look something like this:

ACME Mutual Funds

FBO (For Benefit Of) Mary Smith IRA

123 Main Street

Anywhere Town, USA 55555

It’s easy to tell where your funds are invested by looking at the title. Now that you know how you can invest your Traditional IRA, it’s important to note that there are some areas where you can’t invest, such as purchasing a life insurance policy, collectibles, art, collectibles, and stamps.

There are also restrictions on IRA investing. If you aren’t  covered by an employer’s retirement plan, you’re able to deduct the amount of your contribution from your current income. If you are  covered, there are limitations placed on exactly how much you can deduct from your income. The amount of deductibility is based on your income. As your income reaches certain levels, the deductibility of your IRAs can ultimately cease altogether.

“Living each day as if it were your last doesn’t mean your last day of retirement on a remote island. It means to live fully, authentically, and spontaneously with nothing being held back.” — Jack Canfield

3.     Do You Have a Qualified or Non-Qualified Account?

I’ve worked with first-time clients who feel a little confused about whether or not they have an IRA. What often happens is they go to an investment professional, who talks over their heads and sets up an account for them, but they aren’t sure how their money is allocated. This is one of the reasons why it’s so important to work with a financial professional who’s sensitive to your needs.

The easiest way to tell if you have an IRA is to look at the statement. If you’ve seen statements that include the FBO [your name], followed by IRA, that’s your indicator that this account is known as a “Qualified” (pre-tax) account—meaning retirement account. If you’ve seen statements without  the FBO and IRA, it’s likely a “Non-Qualified” (after-tax) account.

So, what’s the difference? Well, it might blow your mind at how simplistic the differences between Qualified and Non-Qualified accounts are. I used to share this with my clients all the time, and to see the lightbulb go off was awesome—I knew they “got” it!

If you have a “Qualified” (pre-tax) account, all it means is that you will be fully taxed at whatever your current tax bracket is when you start taking distributions from that account (unless it’s a Roth IRA, more on that further down). There are additional investments that are tax-free, but for the most part, this is the most straightforward difference.

If you have a “Non-Qualified” (after-tax) account, you’re taxed on the interest earned every year that you have an interest-bearing account. You can think of it this way—your savings account (that’s offering a barely-there interest rate) is added to your taxable income each year. You’ll know precisely what that taxable amount is when you receive the 1099 INT form the end of January. When factoring in taxes and inflation, the way I look at some of these types of accounts is that you’re losing money safely.  And, again, why it’s essential to work with a financial professional.

So a quick recap: A qualified account is considered a (pre-tax) retirement account, whereas a non-qualified account is regarded as an after-tax account, which can include cash savings accounts, stocks, mutual funds, etc.

“I found out retirement means playing golf, or I don’t know what the hell it means. But to me, retirement means doing what you have fun doing.” — Dick Van Dyke

4.     What’s the Difference in IRAs if You’re Married or Unmarried?

If you’re married and you’re both working, you can each contribute to your own IRAs. IRAs can’t be combined into one joint-account (hence the individual in “Individual Retirement Arrangement”). You get an IRA, your significant other gets an IRA, I get an IRA (insert Oprah’s voice here), and everyone is happy. The fancy word for this is the “commingling” of retirement funds, which you can’t  do.

Now let’s say your spouse is considered “non-working.” The individual who is working can contribute an additional $6,000 per year into a separate account called a Spousal IRA and up to $7,000 if they’re age 50 or older.

If you’re married and you both have retirement plans at work, there are certain income levels where you can’t deduct an IRA at all. So again, it’s important to work with an advisor you’re comfortable with and consult with your tax professional.

“We know what’s in our Cheerios and our retirement accounts because the law requires disclosure.” — Barton Gellman

5.     What Should You Understand About 401(k) Rollovers and IRA Transfers?

Remember the employer-sponsored qualified retirement plan we were talking about? If you have a 401(k) with an employer and leave the job, you can “roll” your entire  401(k) into your own IRA, all without incurring a taxable event. This is called a “rollover.” 

You aren’t creating a taxable event because you’re going from your employer-sponsored qualified retirement plan to your own IRA, which, as you know, is your individual retirement arrangement. Keep in mind that to rollover from your 401(k) to an IRA, there must be “separation of service,” meaning you’re no longer working for that employer.

Here’s another little tidbit worth mentioning when it comes to understanding an IRA “rollover” versus “transfer” of your retirement account to another. These two words get interchanged quite a bit, and they are, in fact, very different!  

So, if you want to “transfer” your existing IRA to another IRA, you could do so without any limitations, as many times as you wish—but be aware, you may incur fees! So, again, IRA trustee transfer to another IRA trustee transfer, you’re good to go.

If you want to “rollover” your existing 401(k) into your own IRA, you can only do one rollover “once” every 12 months. For example, if you have three 401(k) accounts sitting at three previous employers, you could only rollover one of those accounts every 12 months. You could roll them into the same Traditional IRA, one each year, for 3-years. This limitation became effective after January 1, 2015, as there was never a restriction as to how many rollovers could be initiated in any given 12-month timeframe previously.

“You have to put off being young until you can retire.” — Author Unknown

6.     What Do You Need to Know About Roth IRAs?

Now let’s touch on the famous Roth IRA. The Taxpayer Relief Act of 1997 introduced the Roth IRA, and it’s been nothing less than a massive  hit from Day 1. The contributions for the Roth IRA are not tax-deductible as they are for the Traditional IRA, but these are the 3 biggest wins:

  1. Earnings within the Roth IRA aren’t subject to income tax
  2. Earnings are not included in the account owner’s income
  3. Withdrawals (distributions) are tax-free

The contribution limits are the same with the Roth IRA as the Traditional IRA, but what people love is that anyone,  regardless of age, can establish a Roth IRA, provided their income levels don’t exceed certain levels. If you have an employer-sponsored retirement plan, it has nothing to do with eligibility for a Roth IRA, contributions can be made at any age, and don’t have to cease at age 70 ½.

When you have a qualified account that’s a Traditional IRA, it’s on a pre-tax basis.  What this means to you is that any distributions you took, are fully taxable in the year of the distribution, in your current tax bracket.

With a Roth IRA it’s a completely different story.  Since the funds are based on after-tax money, your distributions with a Roth IRA (and your earnings) are tax-free.

You now know the difference between:

  • Traditional IRA versus Roth IRA
  • Qualified versus Non-Qualified Accounts
  • 401(k) Rollover versus IRA Transfer

Understanding IRAs and a few of these basics is just the start you need to get to the retirement you envision and want!

“Retirement is not the end of the road. It is the beginning of the open highway.”  – Author Unknown

If you’re ready to get financially organized or take your finances to the next level, I’m happy to schedule a consultation with you. Click here to learn more about my financial consultation services. Together, we will help you get control of your finances so that they won’t control you!