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What is an IRA? How is a Roth IRA Different? And What’s the Difference Between IRAs and 401(k)s?

Let’s make this clear: retirement plans are for everybody.

Whether your client is young, nearing retirement age, employed, unemployed, self-employed, wealthy, poor, or anything in between, they can build a retirement plan.

When we think of retirement plans, our minds often skip straight to employer-sponsored plans: 401(k)s, 403(b)s, or pensions. But work-sponsored plans aren’t the only options. In fact, the U.S. Bureau of Labor Statistics reported last year that only 67% of private industry workers were offered a retirement plan through their employer.

One retirement plan option that is available to virtually every single U.S. individual regardless of employment status is an IRA.

What is an IRA?

IRAs stand for individual retirement arrangements, although most of us refer to IRAs as “individual retirement accounts”.

An IRA is a tax-advantaged investment vehicle intended to help individuals save for retirement. Investments held within an IRA typically include stocks, bonds, and mutual funds. Most IRAs are administered by banks, credit unions, and brokerage companies, but any institution that has pre-approval from the IRS to administer an IRA can do so.

IRAs are tax-advantaged, meaning the IRS provides certain tax breaks to people who invest in IRAs. Typically, taxpayers are required to report and pay taxes on investment gains, but gains held within an IRA are different; the tax associated with IRAs does not get assessed until the individuals pulls those funds out of the account in retirement. And depending on the type of the IRA (see for example Roth IRAs below), those gains might even be tax free!

What Types of IRAs Are There?

There are a handful of IRAs to choose from, but the most common is a traditional IRA. In a traditional IRA, money goes into the account pre-tax, and the investments grow tax deferred. In retirement, your clients will pay taxes on all distributions they take from their plan. This means that distributions of both principal and interest are taxable, just not currently.

A few other types of IRAs your clients can choose from are:

Roth IRAs

Roth IRAs are fundamentally different from traditional IRAs. Not only are they funded with after-tax dollars versus pre-tax dollars, the investment gains within a Roth account will – in most cases – never be taxed.

Because the tax-free growth in a Roth is so powerful, the IRS prohibits wealthy taxpayers from contributing to Roth IRAs. In 2021, married taxpayers with modified adjusted gross income (MAGI) of $198,000 or less could contribute up to $6,000 annually to a Roth IRA (or $7,000 if they were age 50+). As their income rises, their available contribution phases out. When their MAGI reaches $208,000, they can no longer contribute to a Roth IRA.

SEP IRAs

SEP IRAs – or simplified employee pension IRAs – are for any size employer, but they tend to be popular among self-employed business owners with few employees. SEP IRAs are like traditional IRAs in that money is contributed pre-tax, and the growth is tax deferred until retirement. Two key differences are that (1) the employer can contribute to the plan, but employees cannot, and (2) the employer must contribute equally to each employee based on a percentage of the employee’s compensation.

SIMPLE IRAs

SIMPLE IRAs stands for savings incentive match plan for employees. These plans also resemble traditional IRAs: money is contributed pre-tax, and growth is tax deferred. But SIMPLE IRAs are restricted to only small employers (100 employees or fewer), and employers are required to contribute to the plan each year. SIMPLE IRAs are great options for small employers because the administrative hoops are more manageable than other plans.

Are IRAs Better than 401(k)s?

Traditional IRAs and 401(k)s are similar in many ways. Your client can contribute pre-tax dollars into their account, the interest grows tax deferred, and they pay taxes on those distributions in retirement. But there are some key differences.

401(k)s have higher contribution maximums.

Your clients can only contribute $6,000 (or $7,000 if 50+) to an IRA. The annual contribution limit for 401(k)s is $19,500 in 2021 (or $26,000 if 50+).

401(k) contributions are deferred from employees’ paychecks.

It can be more convenient for your client to have a portion of their paycheck automatically deposited into their 401(k).

401(k)s might have an employer match.

Though not required, some employers match employees’ 401(k) contributions as a benefit to employment. Once your client is vested, this is free, no-strings-attached money. Additionally, the employer match is not considered for your client’s $19,500 annual contribution limits. The only rule is that employer and employee contributions combined must stay below $58,000 (or $64,500 if 50+) in total in 2021.

IRAs tend to have more investment options than 401(k)s.

If your client wants to have more control over their portfolio, an IRA might be the way to go.

Administrative fees in a 401(k) might be cheaper.

As a benefit to employment, many employers subsidize the administrative fees required for a 401(k). IRAs will not have this same option.

IRAs allow for more flexible contributions.

401(k) contributions must be made by the end of the calendar year, but your client can contribute to their IRA up until the tax filing deadline  of the following year.

Who is Eligible for an IRA?

Virtually anybody can open an IRA. As long as your client (or their spouse) has earned income, they can contribute to an IRA.

Prior to 2020, individuals over age 70 ½ could not contribute to an IRA. Fortunately, when Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2019, this age restriction was removed allowing even older adults to contribute to their retirement.

What Are the Deduction Limits?

Not all traditional IRA contributions are tax deductible.

If your client has an employer-sponsored retirement plan or is married to someone who has an employer-sponsored plan, their IRA contribution deductions might be limited. Their deduction will be unlimited when their MAGI is low, but once it reaches a certain amount, the deduction starts to phase out. Once MAGI reaches a predetermined upper limit, they lose their deduction completely.

TRADITIONAL IRA DEDUCTION LIMITS

If your client is filing…Their deduction will begin to phase out once their MAGI reaches…And their deduction will be gone once their MAGI reaches…
SINGLE
MARRIED JOINT
MARRIED SEPARATE
And they have a retirement plan through their employer…$66,000
$105,000
$0
$76,000
$125,000
$10,000
SINGLE
MARRIED JOINT
MARRIED SEPARATE
And their spouse has a retirement plan through their employer…N/A
$198,000
Less than $10,000
N/A
$208,000
$10,000

Are IRAs Worth It?

IRAs are certainly worth considering. Although there are some administrative headaches that come with opening and maintaining an IRA, the benefits far outweigh the difficulties. If your client wants to open an IRA, you’ll need to ensure that they:

  • Report IRA contributions on their tax return, even if they are nondeductible.
  • Contribute no more than the annual amount permitted.
  • Understand the penalties that will be assessed if they pull from their funds prior to retirement.
  • Are familiar with the difference between traditional and Roth contributions.
  • Consider also participating in an employer-sponsored plan, if available.

A simple way to add value to your clients is to talk to them about their retirement plans. During your annual tax planning meeting, ask them how they are saving for retirement. IRAs might be just the thing they were looking for.

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