Retirement
Retirement Planning
Saving for Retirement
14 Min Read | Jan 16, 2024
By Ramsey
By Ramsey
There are a couple things you need to know about how millionaires build their wealth.
First, the vast majority of millionaires (80%) invested in their 401(k) to build their wealth, according toThe National Study of Millionaires. But they didnât stop there. Three out of four millionaires also investedoutsidetheir workplace retirement planâwhich means IRAs likely played a key role in helping most of them reach millionaire status.
But what exactlyisan IRA? And why is it one of the most powerful ways you can save for retirement? Thereâs a lot of ground to cover, so letâs dive right in!
What Is an Individual Retirement Account (IRA)?
An individual retirement account (IRA) is a tax-favored savings account that lets you invest for retirement with some special tax advantagesâeither a tax deduction now with tax-deferred growth, or tax-free growth and withdrawals in retirement.
Remember an IRA isnât an investment itselfâitâs the account thatholdsyour investments and determines how theyâre taxed by the government. Think of your IRA as a sweater that protects your investments from the elementsâthe elements, in this case, being Uncle Samâs cold, harsh taxes.
How Do IRAs Work?
You can open an IRA through a bank, brokerage firm, or with help from a financial advisor. Then you add money to your account (called contributions) to be invested in a wide range of different investmentsâfrom simple savings at a bank (bad idea) to mutual funds and exchange-traded funds (ETFs). And since IRAs arenât limited to the small menu of options offered by your 401(k) plan administrator, you have more control over what investments go inside your IRA.
Investing with an IRA is like having a fast pass at your favorite theme park because you get to skip the tax line in several ways. You can change your investments inside your IRA without paying taxes. Plus, you either wonât owe any taxes until you take your money out in retirement (traditional IRA), or you wonât owe taxes at all (Roth IRA) so long as you wait until age 59 1/2!
And since an IRA is meant to help you save for retirement, donât eventhinkabout taking your money out early. If you take money out before youâre age 59 1/2, youâll get hit by a 10%early withdrawal penalty(on top of whatever taxes you owe).1Plus, youâll miss out on the tax-deferred or tax-free growth of that moneyâand youâll end up way behind on your retirement savings goals.
Who Can Invest In an IRA?
The key phrase to answer that question isearned income,which includes your salary, freelance earnings and holiday bonuses. Anyone with a pulse and an earned income (including children and teenagers) can open up an IRA and contribute to one. Plus, stay-at-home spouses can open up a spousal IRA to save for retirement as well.2
What Is the IRA Contribution Limit?
Unfortunately, the government puts a cap on how much money you can put in these tax-friendly accounts. That limit usually changes every year based on inflation.
For 2024, the totalcontribution limitfor all IRAs is $7,000âthat limit applies to both Roth and traditional accounts. If youâre over 50 years old and behind on your retirement savings, you can invest $8,000 (that extra thousand bucks is called acatch-up contribution).3
Types of IRAs
Weâve already talked about how individuals can open atraditional IRA or Roth IRAto help them save for retirement outside of their workplace plan. But small-business owners and freelancers can also set up a SEP IRA or SIMPLE IRA to help themselves and their employees save for retirement.
Letâs cover all the nuts and bolts of those IRAs (plus a few others) one by one:
Traditional IRA
Traditional IRAs are funded withpretaxdollars, which just means you can lower your tax bill this year by writing off your contributions as a tax deduction. But since youâre not paying taxes on the money you put into your traditional IRA this year, youâll have to pay taxes on that moneyandits growth when you take the money out in retirement (thatâs whattax-deferred growthmeans).
How much will you need for retirement? Find out with this free tool!Traditional IRAs have no income limits. That means anyone and everyone with taxable income can open a traditional IRA and contribute the maximum amount.4
But with a traditional IRA, you have to start making annual withdrawals (calledrequired minimum distributionsor RMDs) after your 73rd birthday.5Why? One word:taxes.You still owe taxes on the money sitting in a traditional IRA, and Uncle Sam wants his cut eventually.
Roth IRA
With aRoth IRA, youâve already paid taxes on the money you put into the account (thatâs whatafter-tax contributionsmeans). The great thing about that is, now you can watch your money grow tax-freeandenjoy tax-free withdrawals in retirement.
If your annual household income isabovea certain amount, you canât open or contribute to a Roth IRA (or you might only get to invest a reduced amount). For Roth IRAs, you can contribute up to the maximum amount as long as your gross income is less than a certain amount (for 2024, itâs $146,000 for single filers and $230,000 for married couples filing jointly).6
Another great thing about Roth IRAs is, you can leave the money in your Roth IRA for as long as youâd likeâno RMDs. That means more time for your money to grow!
If your income is too high to contribute to a Roth IRA directly, thereâs a perfectly legal work-around called abackdoor Roth IRA. First, you invest in a pretax traditional IRA and then roll that account into a Roth IRA.
SEP IRA
SEP IRAis short forsimplifiedemployeepensionplan, andit lets the self-employed and business owners create tax-deferred retirement savings plans for themselves and their employees.
But SEP IRAs only allow theemployerto contribute to the plansâafter all, these plans havepensionright in the name. The great thing about SEP IRAs is, theyâre easy to set up and operate with low administrative costs. They also offer flexibility for employers, who can adjust their annual contributions if money is tight in a down year.
These donât work well if you have long-term employees, though, because you have to contribute the same percentage to their account that you put in yours.
SIMPLE IRA
Another option for small-business owners is theSIMPLE IRA, which stands forsavingsincentivematchplan foremployees. SIMPLE IRAs are start-up retirement savings plans for small businesses with up to 100 employees.
Like the SEP IRAs, SIMPLE IRA plans are easier to set up and simpler to run than most other workplace plans and offer tax-deferred growth (thereâs no Roth option). But thereâs a key difference: SIMPLE IRAs allow both employersandemployees to contribute and share the responsibility of saving for retirement.
The employer either has to match up to 3% to employee accounts or contribute 2% toeveryemployeeâs plan (whether the employees are adding their own money or not).7But the administrative fees for SIMPLE IRAs are much less for the employer than they are with a normal 401(k).
Rollover IRA
If you leave your job, you can alwaysroll over the balance from your 401(k)(or another employer-sponsored retirement plan) into arollover IRA. That way, you can have your investments all in one place instead of leaving behind a trail of orphaned 401(k)s from the jobs you left over the years.
So, what type ofrollover IRAshould you move your money to? It all depends on the type of 401(k) youâre rolling over. If you have a traditional 401(k), for example, youâll probably want to roll those funds into a traditional IRA to avoid getting hit with a tax bill.
But if you have enough cash on hand to pay the taxes for aRoth conversionâwhich means rolling over traditional 401(k) funds into a Roth IRAâitâs an option worth talking over with your financial advisor and a tax pro. We donât recommend doing this unless youâve paid off your housefirst.
Self-Directed IRA
Aself-directed IRA(SDIRA) is very similar to a traditional orRoth IRA, except these accounts let you invest in some âalternativeâ investments regular IRAs often donât. With a self-directed IRA, you can invest in things like precious metals (gold and silver), cryptocurrencies, real estate, and even energy and natural resources (like mineral rights, if you happen to build your house on top of a bunch of oil).
2But hereâs the thing about self-directed IRAs: You probably donât need one. Most of the investments youâd need a self-directed IRA for are super risky and worth steering clear of. After all, do youreallywant to bet your retirement future on something as unpredictable as Dogecoin?
Spousal IRA
Stay-at-home spouses can save for retirement with an IRA too through aspousal IRA. For example, if one spouse works full time while the other is home taking care of the kids, the stay-at-home parent can still have an IRA in their name as part of the working spouseâs earned income.8
Why You Should Invest in an IRA
WeloveIRAs (especially Roth IRAs) for retirement investing. Not only do they offer tax advantages for your retirement savings that are simply too good to pass up, but they also come with benefits that make them ideal for just about anyone who wants to invest for the future.
- You get tax-free or tax-deferred growth.With a traditional IRA, you get a tax break now. With a Roth IRA, you get a tax break later. Either way, you win!
- You have more investing options. When you invest with an IRA, you can pick and choose fromthousandsof different mutual funds. The more options you have, the more likely you are to find great funds to include in your investing portfolio.
- Theyâre not tied to your employer. Unlike a workplace retirement plan,you can open a Roth IRA at any time.And no matter what your employment situation is, it doesnât affect your IRA at all. Thereâs no need to roll over any funds or worry about keeping track of a dozen 401(k)s from old jobs.
- Theyâre accessible and easy to set up.Like we mentioned, anyone with an earned income can take advantage of an IRA, and thereâs no age limit for opening or contributing to an IRA. Plus, it can take as little as a few minutes to set up your account.
How to Open an IRA
Getting your IRA up and running doesnât take a lot of time or a bunch of paperwork. In fact, itâs almost as easy as opening up a checking or savings account at your bank. Hereâs what you have to do:
1. Pick which IRA you want to open.
Traditional or Roth? The choice is up to you, but we recommend a Roth IRA every day of the week (and twice on Sunday) if you meet the income limit requirement and youâre eligible to contribute to one. Tax-free growthandtax-free withdrawals, remember?
2. Open an account online or with an investment pro.
If youâre the do-it-yourself type, you can go the online route and set up your IRA on your own with a brokerage firm. But we think saving for retirement is too important to do on your ownâwhich is why we recommendopening an IRAwith help from an investment professional.
With an investment pro in your corner, you have someone who can help you identify funds to add to your investing portfolio and advise you through the ups and downs of the stock market.
3. Fill out the paperwork.
Nobody likes paperwork (if you do, you should probably talk to someone about that), but it has to be done. Make sure youâve got the following information ready to go when itâs time to fill out the forms:
- Your driverâs license or other government-issued form of photo ID
- Your Social Security number
- Your bankâs routing number and your checking or savings account number
- Your employerâs name and address (optional)
4. Pick and choose your investments.
This is the most difficultâand also the most importantâstep to opening an IRA. Youâve got so many options to choose from, but you want to be careful not to invest in things that are extremely risky (single stocks) or too conservative (bonds).
Thatâs why werecommend investing in a mix of mutual funds. Theyâre made up of stocks from dozensâor sometimes evenhundredsâof different companies, lowering your risk while still giving your investment dollars a chance to grow.
You should specifically spread your investments evenly between four types of mutual funds: growth and income, growth, aggressive growth, and international. Thatâs what investing nerds calldiversification.After all, the last thing you want to do is put all your eggs in one basket because, at some point, youâll probably end up with egg on your face.Yuck.
5. Set up automatic contributions.
More than anything, successful investors make a habit of investing consistently month after month. And the good news is, you can do that byautomating your investingright from the get-go. You can set up payroll deductions, automatic bank withdrawals or direct deposits to fund your IRA so youâll never miss a single month.
Is It Better to Have a 401(k) or IRA?
You might be thinking,What about my 401(k)? Should I invest with an IRA instead of my workplace plan?No! When weâre talking about 401(k)s and IRAs, itâs not an either-or scenarioâitâs both-and!
Your401(k)offers some advantages your IRA doesnâtâlike an employer match and higher contribution limits. When you take advantage of that and your IRA to save for retirement, youâre setting yourself up to become a Baby Steps Millionaire and retire with dignity.
Hereâs the plan: Once youâre out of debt (everything except the house) and have a fully funded emergency fund, you shouldinvest 15% of your gross income for retirement.
But where do you start? Just remember this simple rule:MatchbeatsRothbeatstraditional. Hereâs how your 401(k) and IRA can work together to help you save for retirement:
1. Take the match.
If your employer offers you a match on your 401(k) contributions, start there and invest up to the match. Thatâs free money, and you donât say no to free money.
Do you have a Roth 401(k) and like your investment options? Fantastic! You can invest your whole 15% there and youâre done. If not, thatâs where your Roth IRA comes into play.
2. Max out your Roth IRA.
If you have a traditional 401(k)âor if youâre not super happy with the investments offered through your companyâs planâthen you can move on to the Roth IRA and invest there.
Remember, you can only put up to $7,000 (or $8,000 if youâre 50 or older) into your IRA in 2024. So, itâs very possible you could invest up to the match at work, max out your IRA, andstillnot hit 15%. In that case . . .
3. Go back to your 401(k).
Hereâs your last step! All you have to do is go back to your 401(k) and increase your contributions until you reach 15%. You wonât get a match on that money, but at least your investment dollars can grow tax-deferred or tax-free, depending on what type of 401(k) you have.
Work With an Investment Pro
If youâre ready to take the next step toward a secure retirement future, then itâs time to meet with an investment professional. A good investment professional can answer any questions you might have about IRAs and help you create a strategy for your retirement savings.
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About the author
Ramsey
Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.