Individual Retirement Accounts, also known as IRAs, are one of the many options available for people who want to save for retirement. Understanding how these types of accounts work is crucial if you are looking to put together a new retirement plan or you need to make changes to your existing one.
Even if an IRA isn’t the right choice for you, it can be helpful to know its benefits and drawbacks and consider what they bring to a long-term retirement plan.
This article will explain what an IRA is, how it works, and the different types.
What Is an IRA?
Individual retirement accounts (IRAs) are tax-advantaged savings accounts that individuals can open to make long-term investments and save.
Like an employer’s 401(k) plan, an IRA encourages people to save for retirement. Tax benefits are available to anyone with earned income who opens an IRA. Unlike a 401(k), an IRA can be opened without an employer’s involvement.
Banks, investment companies, personal brokers, online brokerages, and employers offer IRAs.
How Does an IRA Work?
Your money will grow and compound when you invest in an IRA. Various assets, such as stocks, bonds, and other securities, can be invested in. Interest can be accrued on IRA contributions. Investing more can increase your retirement savings.
Investing and contributing to your IRA will determine how much your account balance grows over time.
Contributions to IRAs are limited each year. Contributing to an IRA usually requires earning income (or that of your spouse). In addition, specific withdrawal rules apply. For example, If you withdraw money before age 59, you may be penalized by 10% and subject to a tax bill.
What Are the Different Types of IRA?
You can find a wide variety of IRAs depending on the broker, bank, or investment company you contact about it. For this article, we’ll focus on the two most common ones (traditional IRA and Roth IRA) and three others:
With Traditional IRAs, contributions are usually tax-deductible. For instance, if you contribute $3,000 to a traditional IRA you can reduce your taxable income by $3,000. Retirement withdrawals from traditional IRAs, however, are taxed as ordinary income. In 2022, traditional IRAs have a contribution limit of $6,000 per year. The maximum contribution for people over 50 is $7,000.
Once you reach a certain income level, the amount of your traditional IRA contribution you can deduct is reduced and eventually eliminated if you and your spouse have a retirement plan at work. It’s still possible to contribute, but your contributions aren’t deductible. If you and your spouse do not have retirement plans at work, IRA contributions can be deducted no matter how much your income is.
Traditional IRA distributions generally begin at age 59 1/2. It may be necessary to pay a 10% penalty if you withdraw money before then, though there are some exceptions. When you reach 72, you must begin taking the required minimum distributions.
Roth IRA contributions are not tax-deductible, but withdrawals are tax-free, and investment gains are not taxed. This is an attractive option for investors who expect to retire in a few years.
Because money loses value over time, Roth IRAs can help combat inflation. Taxes on a Roth IRA are like paying taxes on the seed, not the harvest.
If your modified adjusted gross income falls below $144,000 for single filers and heads of household, or $214,000 for married people filing jointly, you may contribute $6,000 ($7,000 if you’re 50 or older).
Your Roth IRA contribution amount phases out based on your income. Contribution limits for Roth and traditional IRAs are combined; if you have both types of IRAs, you can only contribute the maximum between them.
A SEP IRA is generally for self-employed people or small-business owners with few or no employees. The contributions to SEP IRAs are tax deductible, just like with traditional IRAs. The investment growth is tax-deferred, and your distributions are tax deductible until your retirement, at which point they are taxed as income.
The contribution limit for 2022 is 25% of compensation or $61,000, whichever is lower. There is no catch-up contribution for SEP IRAs at age 50+, and minimum distributions are required at age 72. If business owners contribute for themselves, SEP IRAs require proportional contributions for each eligible employee.
Small businesses with fewer than 100 employees can enroll in SIMPLE IRAs (Savings Incentive Match Plan for Employees Individual Retirement Accounts). Contributions are tax-deductible, just like in traditional IRAs. The growth of investments is tax-deferred until retirement when distributions become taxable income. Those under 50 can contribute $14,000 annually to a SIMPLE IRA in 2022. An additional $3,000 can be contributed by people over 50. Contributions from employers are mandatory.
The name rollover IRA comes from the act of transferring assets from an employer-sponsored plan, such as a 401(k), to an individual retirement account (IRA).
Benefits of and Drawbacks of IRAs
Like any investment tool, IRAs have their pros and cons. Let’s take a look at what benefits they bring and the downsides that they have:
Benefits of IRAs
- IRAs offer more investment options than 401(k)s: When it comes to investing your money, 401(k)s don’t give you much choice. IRAs, on the other hand, do not face this issue. The investment options in an IRA are similar to those in a taxable investment account.
- There is more flexibility and liquidity in IRAs than you might imagine: Many flexibility options are available with Roth IRAs in particular. You can withdraw contributions from a Roth IRA before age 59 without paying additional taxes or penalties (which isn’t the case with a 401(k) or traditional IRA). A few exceptions apply; however, you’ll still owe income taxes and a 10% penalty if you take money out of your Roth IRA before retiring. Among the exceptions is the ability of first-time homebuyers to withdraw $10,000 in earnings.
Also, traditional IRAs can be converted to Roth IRAs, providing you with the flexibility of a Roth IRA.
- There are tax advantages to IRAs: IRAs are known for their tax-advantaged status, which encourages you to save money for the future. However, these tax advantages are slightly different depending on the type of IRA you have:
- Contributing to a traditional IRA allows you to deduct your contributions if you don’t have a 401(k) plan at work (or a spouse does). Your contribution to your 401(k) plan at work can still be deducted if your income for 2022 does not exceed $78,000 for a single filer or $129,000 for a married couple filing jointly. Contributions to a retirement plan at work cannot be deducted if your income exceeds the IRS limits. Retirement distributions are taxed as regular income, regardless of whether your contributions were tax deductible.
- With Roth IRAs, you won’t get a tax break for the same year you contribute, but any growth and distributions in retirement (also called “qualified distributions”) will be tax-free. A Roth IRA is not available to everyone. In 2022, if you make $144,000 as a single filer or $214,000 as a married couple filing jointly, you won’t be able to contribute directly to a Roth IRA. There’s a way around it. It is possible to convert a traditional IRA to a Roth IRA by making a nondeductible contribution.
- Contributions to IRAs are limited each year: IRAs have the disadvantage of having relatively low annual contribution limits, making it difficult to save for retirement. 401(k) contributions are limited to $20,500 in 2022, but IRA contributions are limited to $6,000 (unless you are 50 or older).
- Early withdrawal penalties are sometimes imposed on IRAs: When you withdraw funds from a traditional IRA before age 59, you’ll usually have to pay a 10% penalty and income tax. Some exceptions apply, such as if you withdraw up to $10,000 for a first-time home purchase or lose your job and withdraw to pay health insurance premiums. You can typically cancel contributions from Roth IRAs before retirement without paying taxes or penalties. However, you may be subject to a 10% penalty if you decide to withdraw from a Roth IRA before retirement.
- In some IRAs, required minimum distributions are required: A traditional IRA requires you to withdraw at least a minimum amount each year once you reach the age of 72. Based on your age and the “distribution period,” the IRS sets the amount you must withdraw each year based on your account balance at the end of the previous year. This tool from investor.gov can also be used to calculate your RMDs. As a result of RMDs, your earnings cannot compound in a traditional IRA indefinitely. Roth IRAs, however, are exempt from this rule. Roth IRAs don’t require RMDs during your lifetime.
IRAs are one of the most flexible ways to save for retirement, but that flexibility comes with a burden of knowledge and many rules to follow. Before choosing an IRA, you need to understand the contributions, rollovers, distributions, and other essential factors of IRAS. If you need more information about IRAs, you can always visit the website of the IRS.