Things You Should Remember About Automatic IRAs
Retirement savings have always been a complicated topic for investors. The fixed set of procedures requires the knowledge of different retirement accounts, tax benefits and liabilities, contribution rules and withdrawal limits, as well as growth opportunities. Picking the ideal investment instrument is crucial as your future can depend on it. Insufficient savings can create a financial void at a stage in your life where financial security is of utmost importance. On the other hand, saving a corpus that is more than the required amount can lead to a compromised standard of living and extreme frugality that can cause frustration and discontentment.
Some may have the option to enroll in an employer sponsored retirement account, such as the 401(k) retirement account. A 401(k) account presents the opportunity to save for your retirement in an efficient systematic order. However, not all employers offer a 401(k). For those who do not get this option, an automatic Individual Retirement Account (IRA) can be the key choice.
Here are some things you should know and remember about automatic IRAs:
What is an automatic IRA?
An auto IRA is a retirement account for people who do not get the option to save in an employer sponsored traditional retirement account like a 401(k) account or a pension plan. An auto IRA bridges this gap by offering people an instrument to save for their retirement, regardless of the nature of their job or industry. With an auto IRA, the hassles of paperwork and inertia are eliminated.
Oregon was the first state that offered an auto IRA program under its state sponsored IRA program, OregonSaves. The program was launched in 2017. There have been similar programs introduced in states like California, Illinois, Connecticut, and Maryland ever since.
You can either wait for your state to mandate an auto IRA or open one of your own.
How to enroll in an auto IRA yourself?
Opening an auto IRA is a straightforward process. Here’s how you can enroll in an auto IRA:
- You need to have an earned income to be eligible to open an auto IRA.
- You can choose the type of IRA, such as a Roth IRA or a traditional IRA as per your requirements.
- After the account has been opened, you need to select the ‘auto funding’ feature.
- You can select the frequency of transfers to your account as per the annual contribution limit of the IRA set by Internal Revenue Services (IRS) each year.
How does an automatic IRA work?
A majority of employees in the US rely on their Social Security benefits for retirement. Many studies and real statements of retirees have substantiated that Social Security benefits are not sufficient in retirement as the only source of income. This is why tax qualified employer sponsored retirement and pension plans are essential to cover the difference between income and expenses in retirement. An automatic IRA helps here and works in the following ways:
- Employers who do not offer a sponsored retirement plan need to automatically enroll their employees in a private payroll deduction Roth IRA or other similar retirement account.
- Employers who have more than 10 employees working for them and have been operational for a minimum of two years can offer an auto IRA to employees.
- While employers must enroll their employees, they are not obligated to make any contributions to the retirement account.
- The contributions are automatic and made by the employees. They can opt out of the plan anytime they want.
- Employees can increase or decrease their contribution by 5% of the default contribution rate.
- Payroll deductions can be completed with a direct deposit into the account.
- Auto IRAs offer private sector target date funds for investments in most cases. However, there are other investment options available too and employees can make this choice as per their investment goals.
- The IRA is provided by a private sector third party administrator. This third party administrator manages the account and is in charge of providing investment options to employees.
- Employers who offer an auto IRA are entitled to a temporary tax credit as per the total number of employees in their organization who participate in the auto IRA.
What are the pros of an auto IRA?
Auto IRAs offer the following benefits:
- IRAs offer the same features as a 401(k) account: These accounts are similar to a 401(k) account and offer a safe space to save money for future use.
- IRAs can be set up by all employees: They can be used by employees of the unorganized sector as well as the organized sector.
- Opt out anytime of an auto IRA: Employees can opt out of the account anytime they want and use the funds for a financial emergency.
- Auto enrollment in an IRA: The employee gets automatically enrolled once the employer signs up for an auto IRA. A percent of their salary gets automatically deducted and deposited into the IRA.
- No hidden costs in an IRA: There are no additional charges incurred by the employee after the account has been set up.
What are the cons of an auto IRA?
Although introduced with the intention to offer employees the ease of retirement savings, auto IRAs can have some shortcomings, such as:
- No employer contribution in an IRA: The employer has no fiduciary duty to contribute to the auto IRA. The contributions are solely made by the employee and may not amount to a lot in the long run.
- High administrative fees in an auto IRA: There can be high administration costs levied on the returns that can hinder the overall earnings from an auto IRA. For instance, OregonSaves, the country’s first ever state-run retirement plan for employees of the private sector, charges 1% administrative fees on an asset for all kinds of investments. This substantially reduces the returns.
- The flexibility to opt out of an auto IRA may result in inadequate savings: The option to opt out of the account can add flexibility to an auto IRA as employees can use their funds for short term needs and expenses. However, this also leads to inadequate savings in the long run. With no strict withdrawal rules or penalties, employees are likely to withdraw their funds much before retirement and ultimately depend on their Social Security benefits in their golden years. This can present the same financial struggles as in the absence of a retirement saving plan in the first place.
- The outcome of an auto IRA may not be the same for everyone: The final earnings made on the account can be different for different employees depending on their age, income, and discipline to save. If employees start saving in an auto IRA early in life and contribute consistently, they can amass a large corpus. However, employees who start saving at a later stage in life or who withdraw funds before retirement may find no significant savings.
Why are auto IRAs important?
Auto IRAs are essential as there remains a huge gap in the number of people saving for retirement and the number of retirees in the country. Here are some statistics that show the problems existing in the system and how auto IRAs reduce this gap.
- A total of 80% of the US population of tax payers are eligible to contribute to an IRA. However, only 11 % out of these contribute to the account in reality.
- In addition to this, over 50% of workers in the country are employed in organizations or companies that have fewer than 500 employees in total. The smaller the firm, the lower is the likelihood of an employer sponsored retirement plan.
An auto IRA gives all workers a chance to save for their retirement in a systematic fashion. As per a report issued by the Center for Retirement Research at Boston College, 62% of 40,000 eligible workers were contributing to an IRA auto account as of December 2018. These numbers look promising and can increase in the years to come enabling a better funded retirement for all.
Should you opt for an auto IRA?
The choice would completely depend on each individual. Given the fact that there is no employer contribution, auto IRAs can be like any other investment option in some ways. So, employees may choose to invest in stocks, bonds, exchange traded funds, life insurance plans, etc. as a more lucrative way to save for their future. A financial advisor can help make the final decision based on your age, income, and future needs.
To sum it up
Auto Individual Retirement Accounts (IRAs) are a savior for employees who do not have the option to contribute to an employer sponsored plan. However, it is important to note that there can be many limitations to the plan too. Hence, it helps to be well aware of all aspects of these accounts as stated above. The good news is that you can always opt out of an auto IRA if you do not wish to continue. But in the absence of supplementary savings, this can bring in more losses than gains. Just like depending on Social Security benefits should not be your only source of income in retirement, an auto IRA can also be beneficial if combined with other investments.
You can get in touch with a financial advisor in your area to know more about the rules of an auto IRA in your state and how you can enroll in one.