An IRA (individual retirement account) is a special type of investment account that can be used to help you save for retirement. The money contributed will either be given an up-front tax break or tax-exemption in the future depending on how the account is set up.
Similar to an employer-sponsored retirement plan like a 401k, 403b, or 457, the purpose of an IRA is to help people to build their nest eggs and promote financial security. To encourage participation, the IRS provides special tax incentives with these accounts that will ultimately result in more money for your pocket.
In this post, we’ll explain the different types of IRAs as well as go through some of the rules for contributing to one. We’ll also explore why someone would want to open an IRA.
The Two Main Types of IRAs
When opening an IRA, you’ll be asked to choose between two main types: a traditional or Roth. Both are great tools for saving, but each has different characteristics that may make one more beneficial than the other for some people.
Here’s what you need to know:
When money is put into a traditional IRA, those contributions are deducted from the individual’s taxable income for the year, thus giving them a tax break. They won’t pay taxes on this money or any of the investment gains they’ve made from investing until decades into the future when they’re ready to retire and start making withdrawals. This is why you’ll hear someone say that traditional IRAs are “tax-deferred”.
If you’re already contributing to a 401k plan, this is essentially the same arrangement. You’ll get a tax break now and instead pay your taxes in the future.
Named after Senator William Roth, a Roth IRA works the opposite of a traditional IRA.
Contributions to a Roth IRA are not considered tax-deductible for the year, so the individual will pay taxes on their income as they normally would. However, in the future when you’re ready to withdraw that money for Retirement, you won’t owe any taxes on it (since you’ve technically already paid them). This includes any gains you’ve made on the investments while they were inside the Roth IRA. Because of this arrangement, you’ll often hear people refer to Roths as being “tax-free” or “tax-exempt”.
When trying to decide between a traditional or Roth IRA, the main question will be this: Would you rather pay taxes now or in the future?
How Much Can I Contribute to an IRA?
As of 2022, the IRS will allow each IRA owner to contribute up to $6,000 per year (or $7,000 if you’re age 50 and older). Since this requirement is per person, each member of a couple can open their own unique IRA and save a combined $12,000 per year.
To be eligible to contribute to an IRA, there are minimum and maximum income requirements. For the minimum income requirement, you must have earned income for the year. For example, a college student without a taxable income to report to the IRS cannot contribute to an IRA.
For the maximum income requirement, your earnings cannot exceed the limits set by the IRS. This will depend on whether you plan to go with a traditional or Roth-style IRA. Note that for these income rules, there are special exceptions – please see the Other Types of IRAs below.
When Can I Withdraw My Money from an IRA?
Because the purpose of an IRA is to encourage working Americans to plan and save for retirement, withdrawals are not permitted until you’re at least 59-1/2 years old – presumably when you’d be ready to retire. If you withdraw your money before this not only will you owe taxes, but it will also result in a 10 percent penalty.
There are some notable exceptions. The IRS recognizes several instances where you may need the money in an emergency (such as a mental or physical disability) and will therefore allow special hardship withdrawals without penalty. Also, since you’ve already paid taxes on Roth IRA contributions, they’re available for withdrawal tax and penalty-free.
What Investments Can I Have in an IRA?
One of the major advantages of an IRA is that it can be opened at any financial institution of your choice and invested in a wide range of products. These may include:
- Mutual funds
- ETFs (exchange-traded funds)
- CDs (certificates of deposit)
Some accounts can even be used to hold alternative investments such as real estate and commodities (like gold).
This is a major contrast from a 401k where you may only invest in the menu of options that the plan administrator has pre-selected for you.
Other Types of IRAs
There are several other variations of IRAs that exist for specific situations. Here are a few you might encounter.
- Rollover IRA – If you have a 401k with a previous employer, you can move or “roll” those funds over into a traditional IRA with a new financial institution of your choice.
- Spousal IRA – If only one spouse in the marriage is employed, then the IRS will let you open a traditional IRA for the non-working spouse.
- Non-Deductible IRA – If you earn too much for your contributions to a traditional IRA to be considered deductible, then you can still participate by making what are called “non-deductible” contributions. You won’t get the up-front tax break that you normally would with a traditional IRA, but any earnings that grow on your investments will still be tax deferred.
- SEP IRA – Stands for “Simplified Employee Pension”. This is a special type of retirement plan created for people who are self-employed or who make a significant amount of money from a side hustle.
- SIMPLE IRA – Stands for “Savings Incentive Match Plan for Employees”. This is another special type of self-employed retirement plan that’s generally used by small companies with 100 or fewer employees.
Why Should I Open an IRA?
Opening an IRA can be invaluable to preparing for retirement, even if you’re already using another type of plan like a 401k. Whether you ultimately decide to go with a traditional or Roth-style plan, the fact that you’ll be avoiding taxes for years to come will help to grow your net worth beyond what you could do with a regular, taxable brokerage account.
IRAs are also desirable because they give the account owners more control over what they can invest in. Generally speaking, this opens the door to choosing funds with lower expense ratios, which in turn can lead to greater returns over the years. Additionally, most financial institutions do not charge administrative fees as is done with 401k plans, so this is another cost savings.
Overall, a smart strategy is to use your employer-sponsored retirement plan and IRA in conjunction with one another. Leverage the tax-savings opportunities of both to save thousands of dollars off your tax bill each year. From there, you can optimize by choosing which types of IRAs to utilize and how they will benefit your future financial security.