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Explaining Payroll Deduction IRAs

Explaining Payroll Deduction IRAs

American workers who have retirement plans through their employers should take advantage of them. Without a solid retirement plan, security in retirement is uncertain. According to the U.S. Bureau of Labor Statistics, 67 percent of private industry workers have access to some form of retirement plan. While some retirement plans are better than others, that leaves a third of workers in the U.S. without access to an employer-sponsored retirement plan. That also means those workers will not have financial stability when they retire.

Luckily, there are other options for retirement savings besides the traditional 401(k) and 403(b) accounts. For example, workers can still save for retirement using a payroll deduction IRA.

What is a Payroll Deduction IRA?

Payroll Deduction IRAs are individual (not employer-sponsored) retirement accounts. Typically, employees fund their IRA by having automatic deductions from their paycheck, hence the "payroll deduction" plan. In addition, employees can set a dollar or percentage amount that transfers to their retirement account from each paycheck.

Workers can use a Payroll Deduction IRA to fund either a Traditional or Roth IRA. Similar to other individual retirement plans, the payroll deduction account may provide many low-cost investment options. In addition, payroll deduction IRAs are an excellent option for employers that can't offer a traditional retirement plan. The payroll deduction IRA ensures employees can save for retirement.

How Do Payroll Deduction IRAs Work?

Typically, payroll deduction IRAs are set up with a financial institution. Once you determine which institution to use, you will pick either a traditional or Roth IRA. The main difference between the accounts focuses on when you pay your taxes for your contributions. Traditional IRA contributions are tax-free and only paid upon withdrawal. Meanwhile, Roth IRAs charge taxes on your contributions; however, you do not pay taxes upon withdrawal.

Once you establish your account, you can set up your automatic payroll deduction. You can choose either a percentage of your paycheck or a set dollar amount. For example, if each of your paychecks is $5,000, you can have 10% deducted and sent to your IRA account. With this method, you will have $500 deducted each pay period and transferred directly to your IRA. Otherwise, you can choose a fixed-dollar amount to contribute every paycheck instead. Keep in mind that there are limits to how much you can contribute each year to an IRA. Your payroll deduction choices should consider these limits.

You will quickly see the growth of your payroll deduction IRA account over time.

IRA Tax Benefits

IRAs come with certain tax benefits too.

  • Traditional IRA Tax Benefits. Traditional IRAs do not require you to pay taxes on your investments until you withdraw the funds. Therefore, an essential aspect of a traditional IRA is lowering your taxable income each year, meaning you pay less income tax. In addition, this may reduce your adjusted gross income (AGI), which could make you eligible for other tax incentives.
  • Roth IRA Tax Benefits. The main benefit of a Roth IRA is avoiding paying taxes on your contributions upon withdrawal because you paid them before the deposit. In addition, Roth IRAs have no required minimum distributions (RMD), which means you never need to withdraw funds from the account. This perk makes Roth IRAs appealing to those looking to transfer wealth. Additionally, you may withdraw funds equal to your Roth IRA contributions tax and penalty-free, unlike a traditional IRA.

Using Your Payroll Deduction IRA

Thankfully, simplicity and ease of use are attractive benefits of a payroll deduction IRA. You need to establish the account and set up your automatic payments so that you don't have to worry about making contributions yourself.

As you work and earn more money, you will see the overall growth of your account, which will eventually support you during retirement. In addition, payroll deductions do not require government filings like employer-sponsored plans.

It is important to note that payroll deduction IRAs have the same contribution limits as other IRAs. In 2022, The maximum contribution limit for all IRAs for an individual under 50 is $6,000 and $7,000 for those over 50.

Once you retire, your contributions from your payroll deduction IRA will be accessible so you can maintain your financial security well into retirement. However, employees who withdraw contributions before 59 1/2 will be subject to an income tax and 10% penalty.