IRA calculator helps you assess and compare the value of your Individual Retirement Account at retirement. An Individual Retirement Account (IRA) is a tax-advantaged savings plan designed to help you save for retirement. They are unique because they allow investments to grow tax-free. There are different IRAs providing diverse benefits for people who want to protect their retirement savings from taxes. This article provides a breakdown of these plans. The most common IRA designed for individuals is the Traditional IRA and the Roth IRA; you can check out the Roth IRA calculator to learn all about it.
The other less common ones are employer IRA plans such as the SEP IRA and SIMPLE IRA designed for gig workers, freelancers, and small-business owners. Other specialized IRA plans are Payroll Deduction IRA, Profit-sharing plans (PSPs), Defined Benefit plans, Employee Stock Ownership Plans (ESOPs), 457 plans, and so on. The earlier you begin preparing for retirement, the more time you have to exploit the many retirement plans, and we have a dedicated retirement calculator, the right place for you to start. If you are interested in learning about IRA withdrawals or how to calculate RMD for IRA, the RMD calculator will provide all the information you need.
What is an IRA?
An Individual Retirement Account (IRA) is a tax-advantaged savings plan designed to help you save for retirement. IRAs encourage people to invest for retirement by allowing their investments to grow tax-free. An IRA can be self-managed or employer-sponsored. Generally, self-managed IRAs are more flexible because it allows you to control how your retirement contributions are invested. You can choose from a wide range of investment options, such as:
- Mutual funds;
- Exchange-traded funds (ETFs);
- Certificate of deposits (CDs);
- Real estate investment trusts (REITs);
- Money market funds; or even
- Private placements.
This type of IRA can only be opened at an Internal Revenue Service (IRS)-approved financial institution such as a bank or a broker. There, you can take full control of your investment decisions or allow professionals to make them on your behalf based on your risk appetite and goals.
However, the employer-sponsored retirement plans, such as the 401(k), are only offered by an employer who also makes partial contributions towards your retirement as a benefit. But these retirement plans do not offer as many investment options or autonomy as the 'Individual' retirement accounts.
Types of IRAs
All IRAs are designed to encourage people to accrue wealth until retirement or when they turn 59½. Therefore, they include a 10% penalty for early withdrawals before that age. Nevertheless, they come with different rules, tax benefits, and liabilities. The rules dictate how you make contributions and withdrawals or distributions. As an individual, you can open a Traditional IRA, Roth IRA, or a Rollover IRA by transferring the money in your 401(k) plan. Or you can choose to set up a SEP IRA or a SIMPLE IRA as a small-business owner or self-employed person.
The different types of IRAs are as follows:
The Traditional IRA is the most common type of IRA. It allows you to contribute money into your retirement account and grow your investment tax-free. In 2020, the Traditional IRA contribution limit is
$6,000; if you are older than 50 years, you can contribute
$7,000 (an additional $1,000 as a Catch-up contribution). You only pay taxes when you make withdrawals from your account, but your contributions to the Traditional IRA are tax-deductible if you meet certain requirements. So, for instance, if you normally pay
20% as income tax on your hard-earned annual income of $30,000, that is
20% * 30,000 = $6,000; with the Traditional IRA, after making an annual contribution of $6,000 to your account, you only pay the 20% tax on the remainder. Thus, your new income tax would be
20% * (30,000 – 6,000) = $4,800. You will not only be enjoying your investment returns when you begin making withdrawals at retirement, but you will also be saving money if you happen to be in a lower tax bracket when you retire.
There are certain conditions and rules governing withdrawals or distributions from a Traditional IRA.
Unqualified withdrawals before age 59½ incur a 10% penalty, plus income tax. A withdrawal before age 59½ is qualified to avoid the penalty if you make it to cover any of the following expenses:
Higher education expenses such as tuition, fees, or books for yourself or your immediate family.
A first-time home purchase (up to $10,000 limit). A home purchase is considered 'first-time' if you have not owned a home within the last two years, and you must make the purchase within 120 days of taking the distribution.
Childbirth or adoption of your child (up to $5,000 limit in a year).
Unreimbursed medical expenses over 10% of your adjusted gross income (AGI) for the year.
Health insurance premiums while you're unemployed. You must take the distribution within 60 days after you've got a job.
Withdrawal due to a disability or death of the IRA owner, the beneficiaries can take distributions through an Inherited IRA.
Qualified reservist distribution: This exception is for military personnel called to active duty for more than 179 days. Distributions must be taken during the period of active duty.
Substantially Equal Periodic Payment (SEPP): This method allows you to distribute funds from your IRA or other qualified retirement plans before the age of 59½ without incurring penalties for the withdrawals. The IRS calculates the amount distributed per pay period based on life expectancy, account balance, and interest rates. The only caveat is that once you set up SEPP, you must take at least one distribution each year, and you can't modify the schedule of payments until five years have passed or you've reached age 59½, whichever is later.
You must take Required Minimum Distributions (RMD). The RMD is the minimum amount you must withdraw from your retirement account each year after you turn 72 years. RMDs ensure that people don't avoid paying taxes or grow their investment indefinitely. It is a standard feature for most IRAs, except the Roth IRA.
The Roth IRA is similar to the Traditional IRA in many ways, but they differ in the way contributions and distributions are taxed. Unlike the Traditional IRA, the Roth IRA allows you to make tax-free withdrawals after retirement and contributions are taxed before the deposit, so they are not tax-deductible. Also, there is no RMD for a Roth account since you've already paid your taxes. The Roth allows you to grow your investment throughout your entire lifetime and enjoy a tax-free income in retirement. Still, your modified adjusted gross income (MAGI) must be within an acceptable limit to qualify - if you earn too much, you can't open a Roth. Nevertheless, it is the best option if you are not interested in a Traditional IRA's immediate tax break or expect to be in a higher tax bracket when you retire.
A Rollover IRA is a retirement account that allows you to move the funds from your former employer-sponsored retirement plans such as a 401(k) or 403(b) into an IRA. The IRA may be a Traditional or a Roth IRA. You can either roll over your retirement plan into a new IRA or an existing IRA you own. If you roll over into an existing IRA, you can deposit the total accumulated funds at once. That means even though the funds in your retirement plan(s) are beyond the usual annual contribution limit of $6,000 ($7,000 if you are over 50), you can invest everything!
Here's how the Rollover IRA works:
Supposing you switch jobs with an employer-sponsored retirement plan; you have at least 30 days to decide what happens to your plan if it's a 401(k). Usually, you can choose between any of these options:
Cash out: It's never a good idea to empty your retirement account. Aside from the risk of jeopardizing your retirement, you will be charged a 10% penalty by the IRS for early withdrawal, and your employer will withhold 20% as income tax on the amount distributed.
Leave your money in your former employer's 401(k). This is the most uncomplicated course of action, but it's not ideal. You may be charged higher fees as an ex-employee, and you won't have access to HR for your questions.
Rollover into new employer's 401(k): A no brainer. You get fully onboarded to the new company and have the new HR unit at your disposal for all your questions. Also, it makes sense if the administrative fees on the new plan are lower. Finally, you will consolidate your accounts instead of having your retirement funds scattered with different former employers.
Rollover IRA: This is a preferred option since you will become the plan administrator of your IRA. You have full control, more investment options, and lower administrative fees than 401(k). There are two ways to complete your IRA rollover correctly:
Direct Rollover: You request your former employer to transfer the fund from your old retirement plan or 401(k) plan directly to your new IRA provider.
Indirect Rollover: You receive a check from your employer to deposit to your IRA provider yourself. If you follow this route, your employer will withhold 20% of the fund to pay taxes on your distribution, but you can get it back from the IRS if you make a FULL deposit (including the deduction made for taxes by your employer) to your IRA within 60 days. Failure to meet the 60-day deadline or a preliminary deposit of the account balance and the deficit will be considered an early withdrawal, which incurs a 10% penalty and income tax on the amount.
Rollovers are straightforward when you do them between IRAs of the same tax regime. For instance, a 401(k) rollover into a Traditional IRA would be easy because their contributions are made with pre-tax dollars. When rolling over funds into a Roth IRA whose contributions are made with after-tax dollars, the approach would require paying all outstanding taxes to avoid any IRS penalties.
The Simplified Employee Pension (SEP) IRA is designed for self-employed people such as contractors, gig workers, freelancers, and small-business owners. It follows the same taxation rules for withdrawals as a Traditional IRA but allows contributions up to 25% of compensation or
$58,000, whichever is lesser. This contribution is way higher than the $6,000 maximum contribution of Traditional IRAs. If you set up a SEP IRA for your employees, any contribution you make to their accounts is tax-deductible to your business, but the IRS taxes their withdrawals as income.
The IRS also expects you to contribute the same rate to their accounts as you contribute to yours. So, if you contribute the full 25% of your compensation to your account, you must contribute the same 25% of your employees' compensation to their accounts. Unlike generic retirement plans, employees are not allowed to contribute to a SEP IRA, and there is no catch-up contribution for people older than 50.
The Savings Incentive Match Plan for Employees, also known as the SIMPLE IRA, targets self-employed people and small businesses with less than 100 employees. The SIMPLE IRA is relatively more straightforward to set up than a 401(k) plan, and it also follows the same taxation rules for withdrawals as a Traditional IRA. Unlike the SEP IRA, employees can also make tax-deductible contributions to their SIMPLE IRA.
Employers, on the other hand, are mandated to contribute to their employees' accounts following either of two methods:
- match employees' contributions up to 3% of their compensation
- make a fixed-rate contribution of 2% of every employee's compensation up to a maximum salary of $285,000, with no exceptions.
Employees can make a maximum annual contribution of
$13,500 and an additional catch-up contribution of $3,000, i.e., totaling
$16,500 for employees older than 50. However, the SIMPLE IRA has a higher penalty than the Traditional IRA for unqualified early withdrawals. A penalty of 15%, plus the usual 10%, is charged on unqualified early withdrawals within the first two years of participating in the SIMPLE IRA plan. That means, if you make an unqualified early withdrawal before you turn 59½ and you've only been participating in the plan for less than two, you will pay a penalty of 25% in addition to the income tax on the amount distributed.
SIMPLE IRA is a good option for employers who want to avoid regular 401(k) extra administrative fees while providing more investment options for employees. However, some employees may prefer the 401(k) for its higher contribution limit of $19,500 ($26,000 for employees older than 50).
An Inherited IRA, also known as a Beneficiary IRA, is an account set up for people who inherit an IRA or employer-sponsored retirement plan after the original owner dies. The beneficiary inheriting the IRA may be an estate or trust, relative, or spouse.
Depending on your relationship with the original IRA owner and the type of IRA inherited, the withdrawal and taxation rules vary.
Spousal transfer: Spouses are allowed to 'assume' ownership of an inherited IRA if they are the sole beneficiary of the account – they can continue to handle the inherited IRA as if it was theirs after the original owner dies. Or they can roll the funds in the IRA into an existing IRA or create a new IRA.
Non-spousal and Multiple beneficiaries: When a spouse is not the sole beneficiary, or there is more than one beneficiary, funds in the inherited IRA cannot be rolled into an existing IRA. Instead, each beneficiary must formally set up a new IRA for their portion of the asset. This new inherited IRA cannot take contributions, and beneficiaries must withdraw their inheritance by the 10th anniversary of the original owner's death. The exception to this rule only applies:
If you're a spouse to the deceased, you can treat the account as yours.
You're a minor child, then the 10-year rule begins on your 18th birthday.
You're not more than 10 years younger than the deceased, or you're chronically ill or disabled. Then, you can bounce the distribution throughout your lifetime.
There are a lot of other less common specialized IRAs for unique situations. Some of these IRAs are the Spousal IRA, designed for the non-working spouse to fund using their working spouse's income, and the Backdoor Roth IRA, which comes with complex tax strategies for unqualified individuals to own a Roth account. The best IRA is different for everybody. But you can make an informed decision using your retirement goals, tax status, and the uniqueness of your investment options to decide.
How to open an IRA?
You can open an IRA at any IRS-approved financial institution. After deciding what type of IRA you are interested in, the next steps are to:
Compare different IRA plans and select the best deal. You can use the IRA calculator to do this by merely inputting the key figures, and the IRA calculator will output the information you need to make an informed decision. It is also essential that you understand the custodial fees and expenses, investment options, special features, and the degree to which the investments are managed to assess returns accurately. The best IRA providers are customer-centric, so make sure they are paying attention to you.
Choose how you want your account to be managed and choose investment options. If you are interested in actively managing the account yourself, you will need to do research and understand investment strategies, but you get to save on management fees. Otherwise, you can take a handoff approach to your investments by subscribing to less risky but comparably lower return mutual funds or computer algorithms that adjust your asset classes according to your risk tolerance level. The last option is to have professionals help you manage the account for a fee. Be intentional about your choices by asking a lot of questions to make an informed decision.
Decide annual contribute. You can choose to make contributions at once (lump sum deposit) or in monthly installments but ensure that you take full advantage of your contribution limit. You can contribute to both your IRA and your 401(k) plan. Some employers offer to match a percentage of how much you contribute to your 401(k) as a benefit. It is wise to contribute the full value of that match before putting money elsewhere to supplement your savings. And if you need money urgently, you can easily access your 401(k) if you don't want to tap into your IRA.
Open the IRA by making an initial deposit. You can set up an arrangement to have future deposits made directly from your paycheck or bank account. Also, ensure you monitor your investments regularly. Your IRA provider will send a monthly statement on your IRA performance to help you make adjustments as you approach your retirement goals.
Whichever type of IRA you choose, the tax benefits allow your savings to compound quicker than a regular taxable account. Hence, the sooner you get an IRA to work for you, the fewer taxes you pay on your savings, and the more benefit you enjoy at retirement. Don't forget to check out the Roth IRA calculator if you're interested in tax-free withdrawals during retirement.