What Is an IRA?

Definition and Examples of IRAs

Retired couple looking at a map beside a camper van
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IRA stands for "individual retirement account." Tax law provides for many types of IRAs, each designed to help you save for retirement, and taxed in its own way. A traditional IRA, for instance, allows you to put off paying taxes on money you've saved until you're ready to retire. IRAs differ from employer-sponsored accounts in that you can invest on your own terms in many cases, instead of having to choose between a few select funds, as you would with a 401(k).

Choosing the IRA that's best for you will depend on factors such as the age at which you plan to retire, your income, your tax filing status, whether you run a small business, whether you expect to withdraw funds, your long-term goals, and more. Here we cover a few of the most common IRAs.

Key Takeaways

  • IRAs hold many types of assets geared toward helping the account owner save for retirement.
  • The makeup of holdings in an IRA are most often managed by an account custodian, who invests based on your goals and direct input.
  • There are many types of IRAs, some that provide tax deductions in the same year you pay into the account, some that allow you to take money out tax-free at any time, and more.
  • All IRAs come with a number of rules and mandates from the IRS, such as limits on how much you can contribute, and tax penalties if you withdraw funds before a set age.

What Is an IRA?

An IRA itself is not an investment. It is a type of account that acts as a shell or a holder for your investments. You can invest in many types of assets inside a single account. Your IRA provider acts as the custodian of your account, and will invest the money for you in a manner that meets your terms and goals.

How Does an IRA Work?

You can open an IRA account at a bank, brokerage firm, mutual fund company, insurance company, or at a number of other types of financial institutions. Your account will be managed by a broker or other agent of the firm, who will invest your money into CDs, bonds, mutual funds, stocks, and almost any other type of asset on the market. In some cases you may have a degree of control over your account, and you can choose how to direct portions of your fund. There is a wide range of choice in IRAs with regards to types of holdings, as well as how hands-off or hands-on you prefer to be in how the fund invests.

How IRAs Came About

The two main types of IRAs are traditional IRAs and Roth IRAs.

Traditional IRAs were first formed by Congress in 1974, under the Employee Retirement Income Security Act (ERISA). They were created as a way to help people to save for their golden years, and also offer perks for doing so. ERISA provides special tax treatment for funds placed into IRAs. ERISA also sets standards and rules by which these plans must be run in order to protect the people who invest in them, and prevent misuse of funds.

A traditional IRA is best for people who think they'll be in a lower tax bracket after they retire, and for those who don't have access to other retirement plans, such as 401(k)s.

Roth IRAs were brought about as a result of the Taxpayer Relief Act of 1997. The main way they differ from traditional IRAs is in the way they are taxed, which happens at the time funds are put into the account. A Roth IRA account makes sense for people who expect to be in a higher tax bracket when they retire. Also, you can withdraw funds from your Roth account at any time without incurring fees or being taxed, so for many people a Roth IRA can also serve as an emergency fund.

Traditional vs. Roth IRAs

Traditional IRAs Roth IRAs
Contributions are tax-deductible in the year they are made. Funds are taxed when they are withdrawn. Contributions are not tax-deductible, but withdrawals are tax-free.
Early withdrawals are subject to an extra 10% tax fee. Early withdrawals are not subject to taxes.
You must begin taking required minimum distributions at age 70½ if you attain age 70½ by the end of 2019, or until age 72 for others. You do not have to take required minimum distributions.

Traditional IRAs in Detail

The money you contribute to a traditional IRA is tax deductible, so long as you meet certain eligibility requirements. You can still put money into your IRA if it does not meet the standards set each year, just without the perk of being able to deduct it from your taxes. Here are some of the basic features and rules that apply to this type of account:

  • The funds inside the account grow tax-deferred. This means you don't have to pay income taxes on any gains until you take money out, which may be years down the road (and maybe at a time when your tax bracket is much higher).
  • A tax penalty is imposed on any money you take out before age 59½. You'll be charged a 10% fee, plus you'll pay income tax on that money.
  • You must begin taking required minimum distributions by age 70½ if you reach age 70½ by 2019. Those who do not meet that cutoff date can wait until age 72.

In 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act raised the required minimum distribution age for IRAs starting in 2020.

Roth IRAs in Detail

Contributions to a Roth IRA aren't tax-deductible, but the funds inside the account grow tax-free. This means you'll never pay income tax on interest, dividends, or capital gains on funds that grow inside of a Roth IRA as long as you follow the Roth IRA withdrawal rules.​ Roth IRAs have other perks as well:

  • You pay the tax at the time you put money into a Roth IRA, but not when you use it later to retire. This can be a major help later in life if you think your tax bracket might be higher, along with higher tax rates.
  • You can withdraw money from a Roth IRA at any time with no tax owed, so a Roth IRA can double as an emergency savings fund.
  • There is no mandate that you must withdraw funds at any age.

You are able to convert a traditional IRA to a Roth. Just be aware that rules that govern this type of action are very precise with regard to how your income is counted, and it may affect your taxes. The IRS may also adjust the process from one year to the next.

IRA Contribution Limits

The IRS sets a cap on how much you can add to your IRAs each year. It's a collective limit, meaning it applies to all IRA accounts you might hold. In 2020 and into 2021 the limit is $6,000 in, but the IRS adjusts this figure in some years to keep pace with inflation. You can add an extra $1,000 as a "catchup" contribution if you're age 50 or older by the last day of the tax year.

Your taxable income must be equal to these limits or more in order to qualify. If not, your contributions are limited to your taxable income.

You must have some earned income to contribute to any type of IRA, with one exception: You can add money to a spousal IRA for your spouse even if they have no earned income, as long as you have enough to cover both.

You can contribute $3,000 to your Roth IRA and $3,000 to your traditional IRA, but you can't contribute the $6,000 limit to each of them. The limit is an umbrella over all the IRA accounts you hold.

Exceptions to Early Withdrawal Penalties

The IRS offers some leeway on the 10% fees for early withdrawal in certain cases. You can take the amount over and above 7.5% of your adjusted gross income penalty-free, in these cases:

  • Health care: You can use some of your account balance to pay medical bills up to a certain limit. You can also withdraw funds to pay health insurance premiums if you're between jobs.
  • Education: You may be able to use funds to cover the cost of higher education or job training.
  • Buying a home: If you are a first-time homebuyer, you can withdraw funds from your account to aid in this purchase.
  • Disability: If yo plan to claim this exemption, you must have your doctor attest in writing that your disability is "complete and permanent," to the extent that you can no longer perform enough work to earn a living.

IRAs for Small Business Owners

There are two other types of IRAs that offer perks much like the others if you happen to be a small business owner, a sole proprietor, work as a freelancer, or if you engage in any other form of self-employment. These plans are made to be simple with low fees and bare bones administration.

As an owner of a small business IRA, you can withdraw funds from the account at any time, but the money you take out might be subject to income tax and that same 10% fee if you haven't yet reached age 59½.

SEP IRAs

You might be eligible to open a Simplified Employee Pension (SEP) IRA if you own a business or work as a self-employed independent contractor. The SEP IRA offers tax perks to an employer who puts money into this type of account on behalf of an employee.

As the account holder of an SEP IRA, you can contribute up to 25% of a worker's annual salary, but employees can't add money to their own accounts. You also get the added bonus of being able to adjust the amount you choose to add to the account each year, which can differ based on how much profit your business makes that year. Note that each employee must receive the same amount in a given year.

You might be able to add more money to a SEP IRA than what you could add to a traditional or Roth IRA. As of 2020, you could contribute the lesser of $57,000 or 25% of your annual wages with this type of account. In 2021 that limit was raised to $58,000.

SIMPLE IRAs

The Savings Incentive Match Plan for Employees (SIMPLE) IRA is a type of IRA plan that is only for companies with 100 or fewer workers, all of whom must earn at least $5,000 a year. The SIMPLE IRA works much like a standard 401(k) plan, but the annual contribution limit is lower than the $19,500 allowed in 2020 and 2021 for 401(k) plans.

It works on a match system: Employers must match employee contributions at 3%, or put in 2% of the employee's salary, even if the employee doesn't add any money into the account on their own. Employees must be on track to make at least $5,000 in the current year in order to use a SIMPLE IRA.

Like the SEP IRA, a SIMPLE IRA may allow you to add more money to the account than you could with other IRAs. The limit for a SIMPLE IRA was $13,000 in 2019 with an over-55 catch-up contribution max of $3,000 per year. The 2020 limit was raised to $13,500, and remains the same for 2021.

The SIMPLE IRA does impose a 25% fee for any money taken out within the first two years for account holders who have not yet retired.