Chapter 8
Investing in an IRA
IN THIS CHAPTER
Starting with the basics
Opening an IRA
Keeping an eye on your money
Changing locations
Individual retirement arrangements (also known as individual retirement accounts), or IRAs, came into being through provisions added to the internal revenue code (IRC) in 1978. These provisions encourage you and every other American worker to save money for retirement. Tax advantages sweeten the pot, and automatic deductions can make saving nearly painless.
This chapter clues you in to the types of IRAs available, finding the place to put your funds, keeping track of your money, and moving it if necessary.
Looking at the Basics of Your IRA
An IRA is a special type of savings and investment account that helps you save for retirement by providing specific tax advantages. (I talk about the tax issues covering retirement accounts in Chapter 2.)
Federal law limits the amount you can contribute during 2021 to an IRA (or to all your IRAs combined, if you have several) to $6,000 in a single year plus a $1,000 catch-up contribution if you’re at least age 50. The IRS reviews the limits annually and may update them. (Chapter 15 offers details on contributions.) Your contributions are invested and grow tax-free until you withdraw them. All the money you withdraw is taxable except for a Roth IRA. Withdrawals from a Roth IRA aren’t taxable if you follow the rules.
The primary reason for tax advantages that accompany IRAs is to encourage you to save for retirement, so taking funds out before then can be financially painful. If you withdraw funds from your traditional pre-tax IRA before you’re 59½ for any other than a few approved expenses, you pay a 10 percent penalty. The details of early withdrawals are covered in Chapter 16.
As well as saving for retirement, you can use IRA savings for select other purposes — buying your first home or adding a child to your family, for example. If you withdraw money for a specific, approved reason, you must pay tax on the amount you withdraw from a traditional IRA but you don’t have to pay a penalty tax. If you take money out for other than approved purposes, you’re liable for taxes and penalties.
The financial bite for taking money from a Roth IRA isn’t as harsh as from a traditional IRA, although you are liable for taxes on the portion of the investment gains you must withdraw if your Roth IRA is less than five years old. A pro-rata portion of the investment gains must be withdrawn and will be taxable if the Roth IRA is less than five years old but there isn’t an early withdrawal tax penalty. Read on for information on the different types of IRAs, and see Chapter 9 for detailed information about Roth IRAs.
Historically, IRAs haven’t been connected to employers, but that’s changing. Some states are requiring employers that don’t offer a retirement plan to start offering one. Most states have or will have state-run payroll-deduction IRA plans to make it easier for employers to meet these mandates. Oregon has what’s known as the OregonSaves state-run payroll-deduction IRA plan, and a growing number of employees are enrolled in this plan.
Small employers including solo entrepreneurs, family businesses, and gig workers have a number of IRA options that I explain in Chapter 18. These include the SEP IRA and SIMPLE IRA, which are two types of employer-sponsored plans — and self-employment plans.
For more information about IRAs, take a look at IRS Publication 590, Individual Retirement Arrangements, which you can download for free from the IRS website at www.irs.gov/pub/irs-pdf/p590.pdf. (The IRS home page is www.irs.gov.)
Staying traditional
Most IRA holders have traditional IRAs because (as their name suggests) they’ve been around for a while — since 1974.
You can make two types of contributions to a traditional IRA:
- Deductible: You can deduct your contributions from your income for tax purposes.
- Nondeductible: You guessed it — you can’t deduct your contributions. (Who said this financial stuff was complicated?)
With both types of contributions, you don’t pay income tax on your earnings until you withdraw money from the account. You owe income tax when you withdraw the untaxed portion at retirement. With deductible contributions, you owe tax on the contributions plus the earnings. With nondeductible contributions, you owe tax only on the earnings. As you can imagine, if you make both types of contributions to an IRA, you need to keep meticulous records in order to know what’s what when you start withdrawing the money, which can be many years from now.
The deductible IRA is a better deal because you get the extra tax break of being able to deduct your contributions from your taxable income. The catch is that if you have a 401(k) or any other employer-sponsored tax-qualified plan, you can deduct your contributions to an IRA only if your income is below certain limits set out in Chapter 2. (Income means modified adjusted gross income (MAGI), which is your gross income minus certain deductions as defined in detail in IRS Publication 590.) Check Chapter 2 for more info on tax issues.
Even if you participate in a 401(k) plan, you’re allowed to use earned income to contribute to an IRA — earned income is the only acceptable source for IRA contributions. Your spouse can contribute as well even if they don’t work. The only question is whether your contributions will be deductible.
A traditional IRA is typically used for making pre-tax contributions. After-tax contributions to this type of IRA are unusual and are usually made by high-income earners who aren’t eligible to make Roth IRA contributions. Individuals who aren’t covered by an employer-sponsored retirement plan can reduce their taxes by making pre-tax contributions.
Touching on Roth IRAs
You can’t deduct your contributions to a Roth IRA, so in that sense, it’s like a nondeductible traditional IRA. The advantage of a Roth is that the amount you contribute grows without being taxed, and you don’t pay tax on your investment earnings — ever.
As long as you follow all applicable rules, your money grows tax-deferred in the account, and you can withdraw it tax-free at retirement.
You may wonder why anyone would bother with nondeductible contributions to a traditional IRA, where you have to pay tax on withdrawals, when they can have a Roth IRA. Good question. The answer is that you can’t contribute to a Roth IRA if your income is over a certain limit. I go into detail about Roth IRAs in Chapter 9.
Benefiting from a spousal IRA
A spousal IRA is available to a spouse who doesn’t work for pay and who checks the “married, filing jointly” box on their tax form. The togetherness doesn’t hold for the actual IRA, though: The spousal IRA must belong solely to the spouse and cannot be in a jointly held account.
If neither spouse is covered by an employer-sponsored retirement plan, a couple can double the amount of their tax-deductible IRA contributions. If you fit this category, you can contribute between $12,000 and $14,000 to an IRA depending on your age and the age of your spouse. The $6,000 regular and the $1,000 catch-up contribution limits apply to each spouse. A spouse under age 55 can contribute $6,000 and a spouse 55 or older can put in $7,000. One spouse under and one over age 55 results in a $13,000 combined limit.
The money contributed to the spousal IRA can come from any source — the employed spouse’s income, other savings, and so on. However, the contribution can’t exceed the employed spouse’s earned income.
It may also be possible to have a spousal IRA if one of the spouses is covered by an employer-sponsored retirement plan if their combined modified adjusted income is less than $198,000 during 2021. The limit is usually adjusted annually. Check Chapter 2 for more details.
Starting an IRA for a child
You can set up a traditional or Roth IRA for a child or grandchild provided the child has earned income — so, one thing toddlers can’t charm their way into. A parent or other adult can open a custodial traditional or Roth IRA account for a child anywhere IRAs are offered.
Contributions to an IRA that benefits a child can’t exceed the amount of income the child earns.
If you open an IRA account to benefit a child, you have control of the account, including how it is invested and administered, until the child becomes an adult at age 18 or 21, depending on the state. Anyone can contribute to the account. For example, you can contribute to your favorite niece’s account and so can her parents. Just check to make sure that total contributions don’t amount to more than she earned.
You can withdraw funds but only for the benefit of the child. And if you take money out of the IRA, you may create taxable income for the child.
A Roth IRA is the way to go for a custodial IRA for a child if the child doesn’t pay any income tax or is taxed at the lowest tax rate. Also investing aggressively in an attempt to achieve a higher investment return makes sense assuming the time horizon is at least 10 to 20 years. Having funds growing for 50 or more years without any withdrawals would be even better. The potential for early withdrawals also makes a Roth IRA a good option because you can take money out of it for any reason any time after the account is five years old. If the child is over age 59½ when the funds are withdrawn, neither the principal or the earnings are taxable.
Keep in mind that an early withdrawal from a Roth IRA isn’t totally painless because a pro-rata portion of the investment earnings are taxable, and an early withdrawal penalty tax will apply unless the withdrawal is for one of the reasons that qualifies as an exception.
Offering to open and contribute to such an account may encourage a child to earn some income and can also help a young adult discover how to save and invest.
Setting Up Your IRA
Your first step in starting an IRA is selecting a financial institution where your contributions will be deposited and invested. To qualify for the tax advantages, your IRA must be held by a qualified custodian or trustee. The number of possibilities is almost endless because banks, insurance companies, credit unions, mutual fund companies, brokerage firms, and some other entities are considered qualified to offer IRAs.
In choosing the institution in which to invest your IRA money, you need to decide how much investment choice and what level of service you want.
With virtually all major financial institutions offering IRAs, you can invest IRA funds in any legal, traditional investment vehicle. Traditional means stocks, bonds, certificates of deposit (CDs), exchange-traded funds (ETFs), and other publicly traded securities.
Along with brokerage firms, just about any financial organization can now sell you stocks and bonds, including banks and insurance companies. If you buy a mutual fund from a bank, keep in mind that it’s not guaranteed or insured like other more traditional bank investments, such as certificates of deposit (CDs) or plain old savings accounts.
Nontraditional investments include everything else you can legally invest in, including real estate; gold, silver, and other precious metals; and crypto currencies. You need to find a special custodian for nontraditional investments and open a separate account. Investment details are covered in Chapter 13.
I strongly recommend having all your IRA investments in a single traditional or Roth IRA to make it easier to track and manage them.
Deciding where to invest your money
Seeking help from someone you respect is a good idea if you have little-to-no investment experience. Check with family members or friends who have experience and are people you can trust. Asking an accountant, an investment advisor, or another individual you respect are other possibilities.
All entities that offer IRAs are tightly regulated. You don’t invest in the actual entity where you open your IRA unless you’re investing in CDs and/or some annuity products.
Your major consideration is how you want to invest your IRA savings, which is a difficult question if you’re not an experienced investor.
Please note that one type of financial organization isn’t safer than another. Some IRA investors think they receive FDIC (federal deposit insurance corporation) protection when they use a bank to house their IRA account. This is true only when you buy the bank’s CDs. You don’t get FDIC protection when you open your IRA at a bank and invest in mutual funds. Other investment firms such as Vanguard, Fidelity, and Charles Schwab also offer FDIC-backed CDs.
I heard from a 48-year-old woman who’d taken her bank’s advice and invested in two mutual funds. The investments dropped in value by more than 35 percent during the 2008 meltdown, and she was deeply troubled by this because she thought banks were a safe place to invest. She didn’t realize that the mutual funds weren’t guaranteed investments. Keep in mind that stocks, bonds, and mutual funds involve the same level of risk whether you buy them from a bank, stockbroker, or other financial institution.
Spend time getting familiar with the organization you’re considering before you open an account:
- Visit websites to see how easily you can find useful information about the type of account you want to open and get basic investment information.
- Call the technical support number a couple of times to test the quality of support they provide.
I recommend setting up your account where you have access to a broad range of investments. You want a range that includes both low-risk investments and those with growth potential. Having a wide range of investments available gives you the ability to stick with the institution you select for the long term.
Consider one of the top-brand mutual fund companies such as Vanguard, Fidelity, and T. Rowe Price. Charles Schwab and other discount brokerage firms are also a good option. These entities give you access to their own brand of mutual funds plus the option to utilize a brokerage account.
A brokerage account enables you to buy stocks, bonds, CDs, ETFs, and so on. Go to Chapter 13 for more about investing.
Don’t invest your contributions where you pay a front-end fee or a back-end surrender charge. Avoiding these types of investments enables you to move your IRA to another organization if you feel the need.
Opening your account
The easiest way to open your account is online unless you’re dealing with a local institution. You must decide which type of account you want to open — a traditional or Roth IRA — and you will be required to name your beneficiaries. See Chapter 3 for more information about beneficiaries.
You can send money to be invested once the account is open.
Starting with lower-risk investments isn’t a bad idea until you accumulate a meaningful account balance, such as $10,000. At that point you are in a better position to invest more broadly following what I suggest in Chapter 14.
A huge advantage 401(k)s offer is to take money out of your paycheck each pay period. For most workers, having semi-forced savings is an easy way to become successful long-term savers. You can do the same thing with a personal IRA by having money transferred directly from your bank account to your IRA each pay period or every month.
Maintaining Your IRA
You don’t need to follow any specific requirements to keep your IRA ticking along. However, paying attention to a few issues makes sense:
- Keep your beneficiaries up to date. This may be easy to forget when an important life change occurs.
- Track your investments and the value of your account. Don’t hover over your investments — you don’t want to overreact to the daily ups and downs of the investment markets; you just want to keep an eye on them from afar. Your account should contain investments you’re comfortable holding for the long haul, but there are times when a change may be advisable.
Chapter 13 covers investments in a lot more detail.
When you reach your late 30s/early 40s, you need to start devoting more time to overseeing your retirement savings. You want to pay closer attention to the quality of your investment options; the fees you pay; your current and possible future tax situation; and how much access you have to your money, especially without a tax penalty. You need to also be realistic about your ability to
- Save each paycheck or month without it being taken off the top each pay period
- Keep your sticky hands off the money each time an emergency happens
I used to spend time at the end of each year reviewing my retirement accounts. It’s easier to do this if you have only one account or have multiple accounts at the same place — a traditional and Roth IRA, for example.
Moving Your IRA
You may want to move your IRA to a different financial organization at some point for any number of reasons. Perhaps the investment results have been okay, but you aren’t satisfied with the service you receive. You may have made a bad decision when you picked your financial organization initially, or the size of your account may have grown to a point where you want to make investments that aren’t offered by your current financial institution.
Changing to a new financial organization isn’t hard, but it requires some time. You need to open an account with the new entity and then provide the transfer instructions to the old entity. You can probably retain most of your current investments even if you transfer to another financial organization, although this isn’t always the case. For example, if you want to move your IRA to Fidelity and keep your current Vanguard fund investments, you may not be able to do so.
The transfer must occur via a direct transfer from the old entity to the new one. Ask your agent at the new entity if they can manage the transfer process. The major financial organizations are all able to offer a broad range of investments, but they may not have all the ones that you want. Check before you start the transfer process.