Definition and Example of an IRA
An IRA itself is not an investment. It's 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. It will invest the money for you in a manner intended to meet your terms and goals.
How Does an IRA Work?
You can open an IRA account at a bank, brokerage firm, mutual fund company, or insurance company, or at a number of other types of financial institutions. Your account will be managed by a broker or another agent of the firm who will invest your money in CDs, bonds, mutual funds, stocks, and almost any other type of asset on the market.
You may have a degree of control over your account in some cases. You can choose how to direct portions of your fund. There's a wide range of choices in IRAs with regard to types of holdings, as well as how hands-off or hands-on you prefer to be.
Types of IRAs
The two main types of IRAs are traditional IRAs and Roth IRAs. There are also two other types of IRAs that offer advantages much like the others if you happen to be a small business owner or a sole proprietor, work as a freelancer, or 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 a tax penalty if you haven't yet reached age 59 1/2. This can apply to Roth and traditional IRAs as well.
Traditional IRAs were first formed by Congress in 1974 under the Employee Retirement Income Security Act (ERISA). ERISA provides special tax treatment for funds placed into IRAs. It also sets standards and rules by which these plans must be run in order to protect the people who invest in them, and to 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. They differ from traditional IRAs in the way they're taxed, which happens at the time funds are saved in the account. A Roth IRA account makes sense for people who expect to be in a higher tax bracket when they retire.
You can withdraw funds from your Roth account at any time without incurring fees in many cases or without being taxed, so a Roth IRA can also serve as an emergency fund for many people.
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.
You can contribute up to 25% of a worker's annual salary As the account holder of a SEP IRA, but your 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. This can differ based on how much profit your business makes that year. 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. You can contribute the lesser of $61,000 in 2022, up from $58,000 in 2021, or 25% of your annual wages with this type of account, whichever is less.
The Savings Incentive Match Plan for Employees (SIMPLE) IRA is a type of plan for companies with 100 or fewer workers, all of whom must earn at least $5,000 per year. The SIMPLE IRA works much like a standard 401(k) plan, but the annual contribution limit is lower than the limit for 401(k) plans.
This type of IRA works on a match system. Employers must match the employee's contributions at 3% or put in 2% of the employee's salary, even if the employee doesn't add any money to 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 2022 limit for a SIMPLE IRA is $14,000, up from $13,500 in 2021, with a catch-up contribution maximum of $3,000 per year for employees who are age 50 or older.
The SIMPLE IRA imposes a 25% fee for any money taken out within the first two years by account holders who have not yet retired.
Traditional vs. Roth IRAs
|Traditional IRAs||Roth IRAs|
|Contributions are tax deductible in the year they're made. Funds are taxed when they're withdrawn.||Contributions aren't tax deductible, but qualified withdrawals are tax free.|
|Early withdrawals are subject to an extra 10% tax fee.||Qualified early withdrawals are not subject to taxation.|
|You must begin taking required minimum distributions at age 72 (70 1/2 if you attained age 70 1/2 by the end of 2019).||You do not have to take required minimum distributions.|
Traditional IRAs in Detail
The money you contribute to a traditional IRA is tax deductible as long as you meet certain eligibility requirements. You can still put money into your IRA if it doesn't meet the standards set each year, but without being able to deduct the contributions from your taxable income. The basic features and rules that apply to this type of account include:
- The funds inside the account grow tax-deferred, which means you don't have to pay income tax on any gains until you take money out. That may be years down the road, and maybe at a time when your tax bracket will be much lower.
- A tax penalty is imposed on any money you take out before you reach age 59 1/2. You'll be charged a 10% fee, and you'll pay income tax on that money.
- You must begin taking required minimum distributions by age 72, or age 70 1/2 if you reached 70 1/2 before January 1, 2020.
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 advantages as well:
- You pay the tax on the money at the time you contribute it to 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 then.
- You can withdraw your contributions 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 can 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.
Requirements for IRAs
The IRS sets a cap on how much you can add to your accounts each year. It's a collective limit. It applies to all IRA accounts you might hold. The annual limit is $6,000 for tax years 2021 and 2022. The IRS adjusts this figure periodically to keep pace with inflation. You can add an additional $1,000 as a "catch-up" 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. Otherwise, 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 income 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 for all the IRA accounts you hold.
Exceptions to Early Withdrawal Penalties
The IRS offers exceptions to the 10% fees for early withdrawal in certain cases:
- Healthcare: You can use some of your account balance to pay unreimbursed medical expenses that are over and above 7.5% of your adjusted gross income. You can also withdraw funds to pay health insurance premiums if you're between jobs.
- Education: You may be able to use the funds to cover the cost of higher education or vocational school.
- Buying a home: You can withdraw up to $10,000 from your account to aid in the purchase if you're a first-time homebuyer.
- Disability: You can take an early withdrawal without penalty if you're "totally and permanently" disabled and you can prove that you can no longer perform enough work to earn a living. You must have your doctor attest in writing that your condition is expected to result in death or to last continuously for a long and indefinite period.
- IRAs can hold many types of assets.
- The 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, including some that provide tax deductions in the same year you pay into the account and some that allow you to take money out tax free at any time.
- 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.
Internal Revenue Service. "SEP Retirement Plans for Small Businesses," Page 6.
Internal Revenue Service. "SIMPLE IRA Withdrawal and Transfer Rules."
Congressional Research Service. "Individual Retirement Account (IRA) Ownership: Data and Policy Issues," Page 1.
Congressional Research Service. "Summary of the Employee Retirement Income Security Act (ERISA)," Page 24.
Congressional Research Service. "Traditional and Roth Individual Retirement Accounts (IRAs): A Primer," Pages 9, 11.
Internal Revenue Service. "Simplified Employee Pension Plan (SEP)."
Internal Revenue Service. "SEP Contribution Limits (Including Grandfathered SARSEPs)."
Internal Revenue Service. "SIMPLE IRA Plan."
Internal Revenue Service. "IRS Announces 401(k) Limit Increases to $20,500."
Internal Revenue Service. "Traditional and Roth IRAs."
Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs."
Internal Revenue Service. "Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs)," Pages 30-31.
Internal Revenue Service. "Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs) [Draft]," Page 28.
Internal Revenue Service. "Retirement Topics - Catch-Up Contributions."
Internal Revenue Service. "Retirement Topics - IRA Contribution Limits."
Internal Revenue Service. "Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs)," Pages 24-27, 30-31.