IRA stands for "individual retirement account." A traditional IRA allows you to put off paying taxes on money you've saved and invested until you retire. You can invest on your own terms in many cases instead of having to choose between a few company funds as you would with a 401(k).
Tax law provides for several different types of IRAs, depending on your goals and your other factors.
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 different types of assets inside the account. Your IRA provider would act as the custodian of your account, and will invest the money for you according to your terms.
- Alternate name: Individual retirement account
How Does an IRA Work?
You can open an IRA account at a bank, brokerage firm, mutual fund company, insurance company, or at various other types of financial institutions. you can self-direct your IRA investments in some cases, choosing to use the money you deposit into your IRA to invest in CDs, government bonds, mutual funds, stocks, and almost any other type of financial investment.
Types of IRAs
The two main types of IRAs are traditional IRAs and Roth IRAs.
Traditional IRAs were first introduced by Congress in 1974 by the Employee Retirement Income Security Act (ERISA) as a way to encourage people to save for retirement by offering special tax treatment for funds placed into IRAs. A traditional IRA is best for workers who think they'll be in a lower tax bracket after retirement, and people who don't have access to other retirement plans such as 401(k)s.
ERISA imposes minimum standards and guidelines by which these retirement plans must operate to protect the individuals who invest in them.
Roth IRAs were introduced by the Taxpayer Relief Act of 1997, and they have different tax rules than traditional IRAs. A Roth IRA account makes sense for people who expect to be in a higher tax bracket when they retire. You can withdraw your Roth contributions penalty-free at any time, so a Roth IRA can also serve as an emergency fund.
Traditional vs. Roth IRAs
Contributions to a traditional IRA are tax deductible if you meet certain eligibility requirements, which makes them attractive in the here-and-now. you can still make a non-deductible IRA contribution if you're not eligible for the tax deduction, however. Other rules apply as well:
- The funds inside a traditional IRA grow tax-deferred. You don't have to pay income taxes on interest, dividends, and capital gains until you take a withdrawal.
- But a tax penalty is imposed on early traditional IRA withdrawals if you taken them before age 59½. It's 10%, plus you'll pay income tax on that money.
- You must begin taking required minimum distributions by age 70½ if you reached age 70½ by 2019. Otherwise, you can wait until age 72.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 raised the required minimum distribution age for traditional IRAs beginning in 2020.
Contributions to a Roth IRA aren't tax-deductible, but the funds inside a Roth IRA grow tax-free. You'll never pay income tax on interest, dividends and capital gains on funds that accumulate inside of a Roth IRA as long as you follow the Roth IRA withdrawal rules. Roths have other advantages as well:
- You pay taxes when you retire and withdraw the funds from a traditional IRA, but you pay the tax at the time you make contributions to a Roth IRA. This can be an advantage later in life if you think your individual tax bracket might be higher along with higher tax rates.
- You can withdraw amounts contributed to a Roth at any time with no penalty tax owed, so a Roth IRA can double as your emergency fund.
- Roth IRAs don't have required minimum distributions at any age.
You can convert a traditional IRA to a Roth. Note: Rules on conversions are different than rules on contributions.
|Traditional IRAs||Roth IRAs|
|Contributions are tax deductible in the year they're made. They're taxed when they're withdrawn.||Contributions are not tax deductible, but withdrawals are tax-free.|
|Early withdrawals are subject to a 10% tax penalty.||Early withdrawals of contributions aren't subject to a tax penalty.|
|You must begin taking required minimum distributions at age 70½ if you attain age 70½ by the end of 2019. Otherwise, you can wait until age 72.||You do not have to take required minimum distributions.|
IRA Contribution Limits
The IRS sets a cap on how much you can contribute to your IRAs annually. It's a collective limit, applying to all IRA accounts you might hold. It's $6,000 in 2020 and 2021, but it's adjusted occasionally to keep pace with inflation. You can contribute an additional $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 to qualify. Otherwise, your contributions are limited to your taxable income.
You have to have some earned income to contribute to any type of IRA—with one exception. You can contribute to a spousal IRA for your spouse even if they have no earned income, as long as you personally have sufficient earned income to cover those contributions.
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
Some exceptions apply to the 10% early withdrawal penalty on traditional IRAs.
You can use some of your account balance to pay medical bills up to a certain limit. You can take the amount over and above 7.5% of your adjusted gross income penalty-free. You can also withdraw funds to pay health insurance premiums if you're between jobs, or to cover higher education expenses. Even a first-time home purchase is allowable.
You must have your doctor certify that you are completely and permanently disabled to claim the disability exemption, to the extent that you can no longer perform enough work to earn a living.
IRAs for Small Business Owners
You can take advantage of two other types of IRAs that offer benefits similar to the traditional and Roth IRAs if you're a small business owner, a sole proprietor, work as a freelancer, or engage in any other form of self-employment. These plans are simplified with low fees and minimal administration.
Money can be withdrawn from them immediately, but withdrawals might be subject to income tax and that 10% penalty if the account owner hasn't yet reached age 59½.
You might be eligible to establish a Simplified Employee Pension (SEP) IRA if you own a business or work as a self-employed independent contractor. The SEP IRA provides tax benefits to the employer when you make contributions to an account for the benefit of an employee.
An employer can contribute up to 25% of a worker's annual salary, but employees can't add money to their own accounts. The employer has the flexibility to pay different amounts into the SEP IRA accounts each year, based on the profits generated by the business. Each employee must receive the same contribution amounts.
You might be able to make a larger contribution to a SEP IRA than what you could make to a traditional or Roth IRA. You can contribute the lesser of $57,000 as of 2020 ($58,000 in 2021) or 25% of your annual wages with this type of account.
The Savings Incentive Match Plan for Employees (SIMPLE) IRA is a type of IRA plan that's limited to companies with 100 or fewer workers, all of whom earn at least $5,000 a year. The SIMPLE IRA works in a similar way to 401(k) plans, but the annual contribution limit is lower than the $19,500 allowed in 2020 and 2021 for 401(k) plans.
Employers must match employee contributions at 3%, or put in 2% of the employee's annual salary, even if the employee doesn't contribute. Employees must be on track to make at least $5,000 in the current year to qualify to use a SIMPLE IRA.
Like the SEP IRA, a SIMPLE IRA can allow you to make a larger contribution than what you could make to a traditional or Roth IRA. The contribution limit for a SIMPLE IRA was $13,000 annually in 2019 with an over-55 catch-up contribution max of $3,000 per year. The 2020 limit increases to $13,500 and remains the same for 2021.
Any withdrawals from a SIMPLE IRA within the first two years incur a 25% penalty for non-retired account holders, however.
- Individual retirement accounts (IRAs) hold various types of investments to help save toward retirement.
- An account custodian typically manages the investments according to your wishes and direction.
- There are multiple types of IRAs, some providing tax deductions in the year you make contributions and some providing for tax-free withdrawals.
- All IRAs come with numerous rules and requirements, from limits on how much you can contribute to tax penalties if you take withdrawals before retirement age.