What are retirement accounts and why do I need them?
Individual Retirement Accounts (IRAs) are plans to set aside money that you can use after you retire. They are powerful tools that everyone should use, because IRAs give you income after you stop working and offer tax advantages that can help you save even more.
IRAs are especially important for freelancers, contractors, and the self-employed, because these workers don’t have pensions or retirement plans offered by an employer.
Why not simply put money for retirement in a savings account? Two main reasons. (1) There are big tax advantages to different types of retirement accounts, and (2) the money is invested, so it has the opportunity to grow over time. Tax advantages and investment gains might look small over short periods of time, but over decades they can add up to huge sums of money, which can help you retire comfortably later in life. That’s why it’s also useful to start contributing to your retirement accounts early, so the money has a longer chance to grow.
Catch offers all three of the following types of IRAs. Here is an outline each:
1. Traditional IRA
You contribute a portion of your income to this account using what’s called “pre-tax dollars.” This means that the amount you contribute is not taxed during the year you contributed it. Instead, the money is taxed when you withdraw it upon retirement.
Because you don’t pay taxes on the money you put into your Traditional IRA when you put it in, this type of IRA is called a “deferred-tax account,” which just means that you’re not paying taxes on those funds until you withdraw the money (and any capital gains) later in life.
What this also means is that you get a tax deduction in the year you contribute in the amount you contribute. In other words, the income that you contribute to your Traditional IRA reduces your tax burden that year.
You don’t pay taxes on contributions until you are 72 years old, at which time you are required to take distributions.
The maximum you can contribute is $6000 in 2022 ($6500 in 2023). If you’re over 50 years old, the maximum contribution is $7000 in 2022 and $7500 in 2023).
2. Roth IRA
Unlike a Traditional IRA, you contribute to a Roth IRA with “post-tax dollars,” so you pay taxes on the front end when you contribute it, but not on the back end when you take it out.
What that means is a Roth IRA allows you to contribute post-tax dollars that grow tax-free, so all the money you contribute - plus interest and plus capital gains over time - won’t be taxed when you take it out later in life. This can be a very powerful tool for growing money over long periods of time, especially if you start contributing to a Roth IRA when you’re young.
After the age of 59½, you can withdraw funds from your Roth IRA without paying any penalties or taxes, so long as the account has been open for five years.
Contribution limits: for single filers, you can’t contribute if your income is over $144,00 ($153,000 in 2023), and for married couples filing jointly, you can’t contribute if your income is over $214,000 ($228,000 in 2023). Note that this is a difference compared to Traditional IRAs, where there are no income limits.
Another benefit worth noting is that you have the ability to pass your Roth IRA to your heirs tax-free. If you don’t need the money, then your heirs will be able to use those funds tax-free for as long as 10 years. This is another important difference compared to a Traditional IRA, which forces you to take distributions starting at age 72.
3. SEP IRA
SEP IRA stands for Simplified Employee Pension (SEP) and is a flexible retirement plan that allows you to contribute more when business is strong and to cut back as needed. It’s also referred to as the “Self-employed IRA.” However, it’s also available for small business owners and their employees.
The amount you can contribute is based on a percentage of your income and also capped at a certain total amount. For the year 2022, individuals can contribute 25% of their income or $61,000, whichever is less ($66,000 for 2023).
It’s important to know that you can contribute much more money to a SEP IRA than you’re allowed to contribute to a Traditional IRA or a Roth IRA. So, if you have income from self-employment, then a SEP IRA can be a great way to save a lot more for retirement.
It’s also worth noting that if you contribute to a SEP IRA, you can also still contribute to a Traditional or Roth IRA. Saving in more than one retirement account, especially if you’re able to maximize your contributions in each, can help you save even more for retirement.
Like a Traditional IRA, the money you contribute to a SEP IRA on the front end is tax deductible, and the money you take out on the back end as a distribution is taxed as income.
It’s a great practice to save as much as you can, especially early in life, so that the investments in your retirement accounts can grow for as long as possible. The more time investments have to grow, the more the magic of compound interest can turn even small, regular contributions into very large sums of money.
That said, it is never too late to start saving for retirement. The IRS has also made special allowances for people over 50 by increasing the maximum contributions allowed.