What Is an IRA?
An individual retirement account (IRA) is a long-term savings account that individuals with earned income can use to save for the future while enjoying certain tax advantages. The IRA is designed primarily for self-employed people who do not have access to workplace retirement accounts such as the 401(k), which is available only through employers.
You can open an IRA through a bank, an investment company, an online brokerage, or a personal broker.
Key Takeaways
- Individual retirement accounts (IRAs) are retirement savings accounts with tax advantages.
- Types of IRAs include traditional IRAs, Roth IRAs, Simplified Employee Pension (SEP) IRAs, and Savings Incentive Match Plan for Employees (SIMPLE) IRAs.
- Money held in an IRA usually can’t be withdrawn before age 59½ without incurring a hefty tax penalty of 10% of the amount withdrawn.
- There are annual income limitations that apply to deducting contributions to traditional IRAs and contributing to Roth IRAs.
The age for taking required minimum distributions (RMDs) has been raised to 73 from 72 as of Jan. 1, 2023. That’s for withdrawals from traditional IRA and 401(k) accounts as well as SIMPLE and SEP IRAs. (Roth account owners aren’t subject to RMDs.) The penalty for failing to take an RMD has also been lowered, but it’s still severe at 10% to 25% of the amount not withdrawn.
:max_bytes(150000):strip_icc()/IRA_V1_4194258-7cf65db353ac41c48202e216dfbd46ee.jpg "Individual Retirement Account (IRA): What It Is, 4 Types (1)")
How Does an IRA Work?
Anyone with earned income can open and contribute to an IRA, including those who have a 401(k) account through an employer. The only limitation is on the total that you can contribute to your retirement accounts in a single year.
When you open an IRA, you can choose to invest in a wide range of financial products, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds.
There are even self-directed IRAs (SDIRAs) that permit investors to make all the investing decisions. SDIRAs offer access to a broader selection of investments, including real estate and commodities. Only the riskiest investments are off-limits.
There are several kinds of IRAs, each with different rules regarding eligibility, taxation, and withdrawals. These types include:
- Traditional IRAs
- Roth IRAs
- Simplified Employee Pension (SEP) IRAs
- Savings Incentive Match Plan for Employees (SIMPLE) IRAs
Individual taxpayers can establish traditional and Roth IRAs. Small business owners and self-employed individuals can set up SEP and SIMPLE IRAs. An IRA must be opened with an institution that has received Internal Revenue Service (IRS) approval to offer these accounts. Choices include banks, brokerage companies, federally insured credit unions, and savings and loan associations.
Because IRAs are meant to be a vehicle to invest and maximize the growth of funds for retirement savings, there is usually an early withdrawal penalty of 10% if you take money out before age 59½. However, there are some notable exceptions—withdrawals for educational expenses and first-time home purchases, among others.
If your IRA is a traditional account rather than a Roth account, you will also owe income tax on an early withdrawal. A Roth account is funded with post-tax money, so no further taxes are due when the money is withdrawn.
What Counts As Income?
You can only contribute to an IRA if you have earned income. Income from interest and dividends, Social Security benefits, or child support does not count.
What Are the Different Types of IRAs and Their Rules?
The following is a breakdown of the various types of IRAs and the rules regarding each one.
Traditional IRA
In most cases, contributions to traditional IRAs are tax deductible. So, if you put $4,000 into an IRA, your taxable income for the year decreases by that amount.
Your money grows tax-deferred in a traditional IRA. When you withdraw the money after retiring, it is taxed at your ordinary income tax rate for that year.
Contribution Limits for 2023 and 2024
For 2023, the maximum annual individual contribution to traditional IRAs is $6,500. If you are age 50 or older, you can also contribute a catch-up contribution of $1,000 for a total of $7,500.
For 2024, the maximum annual individual contribution is $7,000. The catch-up contribution continues to be $1,000 for those 50 and over.
If you don’t have a retirement plan at work, your traditional IRA contributions are fully deductible. But if you (or your spouse, if you are married) have a retirement plan at work, such as a 401(k) or 403(b), your modified adjusted gross income (MAGI) determines whether, and how much of, your traditional IRA contributions can be deducted.
If You Have a Retirement Plan at Work
For 2023, if you are single or file as head of household and have a retirement plan at work, your traditional IRA contributions are fully deductible if your MAGI is below $73,000. For 2024, your MAGI must be below $77,000.
If you are married and filing jointly, for 2023, your traditional IRA contributions are fully deductible if your MAGI is below $116,000. For 2024, your MAGI must be below $123,000. From there, the deductibility of your contributions starts to phase out as your MAGI increases.
It is possible to have both a Roth IRA and a traditional IRA, or several IRAs at different institutions. However, the total annual contribution to all of your IRAs cannot exceed $6,500 (or $7,500 for those age 50 or older) for 2023 and $7,000 (or $8,000 for those age 50 or older) for 2024.
For 2023, the income range that phases out the deductibility of traditional IRA contributions for married couples is $116,000 to $136,000. For 2024, it's $123,000 to $143,000.
For single taxpayers or heads of households, the phase out range for 2023 is $73,000 to $83,000. For 2024, it's $77,000 to $87,000.
If You Don't Have a Plan at Work but Your Spouse Does
If you contribute to an IRA and aren't covered by a workplace plan but are married to someone who is, the income phase-out range in 2023 is $218,000 to $228,000. For 2024, it's $230,000 to $240,000.
Use this chart to see where you fit.
| Deduction Limits If You Have a Retirement Plan at Work | |||
|---|---|---|---|
| Filing Status | 2023 MAGI | 2024 MAGI | Deduction |
| Single or Head of Household | |||
| $73,000 or less | $77,000 or less | Full deduction up to your contribution level | |
| More than $73,000 but less than $83,000 | More than $77,000 but less than $87,000 | Partial deduction | |
| $83,000 or more | $87,000 or more | No deduction | |
| Married Filing Jointly | |||
| $116,000 or less | $123,000 or less | Full deduction up to your contribution level | |
| More than $116,000 but less than $136,000 | More than $123,000 but less than $143,000 | Partial deduction | |
| $136,000 or more | $143,000 or more | No deduction | |
| Married Filing Separately | |||
| Less than $10,000 | Less than $10,000 | Partial deduction | |
| $10,000 or more | $10,000 or more | No deduction | |
Roth IRA
Roth IRA contributions are not tax deductible in the year in which you make them. But the distributions are tax-free. That means you contribute to a Roth IRA using after-tax dollars and pay no taxes even on your investment gains.
Also, Roth IRAs do not have required minimum distributions (RMDs). If you don’t need the money, you don’t have to take it out of your account. You can contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.
Roth IRA contribution limits for the 2023 and 2024 tax years are the same as they are for traditional IRAs. However, there is a catch: There are income limitations on contributions to a Roth IRA.
The phase-out range for single filers is $138,000 to $153,000 for 2023 and $146,000 to $161,000 for 2024. For married couples filing joint taxes, the phase-out range is $218,000 to $228,000 in 2023 and $230,000 to $240,000 in 2024.
| Income Limits for Contributing to a Roth IRA | |||
|---|---|---|---|
| Filing Status | 2023 MAGI | 2024 MAGI | Contributions |
| Single or Head of Household | |||
| Less than $138,000 | Less than $146,000 | Up to the limit | |
| $138,000 to less than $153,000 | $146,000 to less than $161,000 | Reduced amount | |
| $153,000 or more | $161,000 or more | Zero | |
| Married Filing Jointly or Qualifying Widow(er) | |||
| Less than $218,000 | Less than $230,000 | Up to the limit | |
| $218,000 to less than $228,000 | $230,000 to less than $240,000 | Reduced amount | |
| $228,000 or more | $240,000 or more | Zero | |
| Married Filing Separately | |||
| Less than $10,000 | Less than $10,000 | Reduced amount | |
| $10,000 or more | $10,000 or more | Zero | |
SEP IRA
Self-employed individuals such as independent contractors, freelancers, and small-business owners can set up SEP IRAs.
A SEP IRA adheres to the same tax rules for withdrawals as a traditional IRA. For 2023, SEP IRA contributions are limited to 25% of compensation or $66,000, whichever is less. For 2024, the maximum allowed contribution is $69,000.
Business owners who set up SEP IRAs for their employees are able to deduct the contributions that they make on behalf of employees. However, the employees cannot contribute to their own accounts, and the IRS taxes their withdrawals as income.
SIMPLE IRA
The SIMPLE IRA is also intended for small businesses and self-employed individuals. This type of IRA follows the same tax rules for withdrawals as a traditional IRA.
Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions as well. All the contributions are tax deductible, potentially pushing the business or employee into a lower tax bracket.
The SIMPLE IRA employee contribution limit is $15,500 in 2023 and the catch-up limit (for workers ages 50 and older) is $3,500. For 2024, the contribution limit is $16,000 and the maximum catch-up amount remains $3,500.
Wash-Sale Rule and IRAs
In 2008, the IRS issued Revenue Ruling 2008-5, which states that IRA transactions can trigger the wash-sale rule. Should shares be sold in a non-retirement account, followed by the purchase of substantially identical shares in an IRA within a 30-day period, the investor cannot claim tax losses for the sale. The investment’s basis in the individual’s IRA won’t increase, either.
What Are Required Minimum Distributions (RMDs)?
Required minimum distributions (RMDs) are withdrawals that owners of traditional IRA and 401(k) accounts must take every year after they reach a certain age. The age has been revised upwards a couple of times. As of Jan. 1, 2023, an account holder must begin taking money out in the year he or she turns age 73, rising to 75 in 2033.
The amount a person must withdraw is based on the account size and the person's life expectancy, so the IRS has a worksheet to calculate the amount. Failure to take the minimum triggers a severe tax penalty. In 2023, that penalty is 25% of the balance of the account. That's half the previous penalty but still expensive enough to keep us on our toes. This penalty can be reduced to 10% in many cases, however, if the taxpayer takes corrective action early.
Comparing IRA Options
Use the chart below to get a better sense of how the different IRAs work.
Note: To view the full chart, use the slider at the bottom to see the column at the far right.
| Comparing IRA Types | |||||
|---|---|---|---|---|---|
| IRA Type | Contribution Limit (2023) | Tax-Deductible Contributions? | Tax-Free Distributions? | Subject to Required Minimum Distributions Beginning at Age 73? | Who Can Establish |
| Traditional | $6,500; $7,500 if age 50 or older ($7,000; $8,000 if age 50 or older in 2024) | Yes, but individual deduction amounts are based on income, filing status, and retirement plan coverage through your employer | No | Yes | Individual taxpayers and couples |
| Roth | $6,500; $7,500 if age 50 or older ($7,000; $8,000 if age 50 or older in 2024) | No | Yes | Not in the account holder’s lifetime (heirs of Roth accounts are subject to RMDs) | Individual taxpayers and couples, subject to MAGI limitations |
| SEP | The lesser of 25% of compensation or $66,000 ($69,000 in 2024) | Business deductions for employee contributions are limited to the lesser of your total contributions or 25% of employees’ compensation. Self-employed individuals must use a special formula to calculate the amount of contributions that they can deduct. | No | Yes | Small business owners and self-employed individuals |
| SIMPLE | $15,500;$19,000 if age 50 or older ($16,000; $19,500 if age 50 or older in 2024) | All contributions made to employees’ SIMPLE IRAs by the plan owner are tax deductible—self-employed individuals can also deduct contributions made to their own SIMPLE IRA | No | Yes | Small business owners and self-employed individuals |
What Does IRA Stand For?
The acronym "IRA" is used to refer to two distinct but overlapping concepts.
For the Internal Revenue Service, the term stands for "individual retirement arrangement." The agency uses this to refer to the broad umbrella of plans available that provide tax advantages to people saving for retirement.
In common usage, IRA also stands for "individual retirement account," referring to a type of a fund that one can pay into throughout their career and withdraw from in retirement, for instance a traditional IRA or a Roth IRA. In such cases, a plan would be both a retirement account for a specific person, as well as an individual retirement arrangement in the eyes of the IRS.
What Are the Advantages of an Individual Retirement Account (IRA)?
An individual retirement account (IRA) offers a tax-advantaged way to save for retirement. Depending on what type of IRA you use, an IRA can reduce your tax bill either when you make contributions or when you take withdrawals in retirement. Investment gains are tax deferred (for a traditional IRA) or tax-free (for a Roth IRA).
That means contributing money towards your retirement either reduces your taxes on income for the year or eliminates the taxes from your retirement money.
IRAs are insured by the Federal Deposit Insurance Corp. (FDIC) a government-run agency that provides protection when a financial institution fails. The FDIC covers customer deposits—up to $250,000 per account in most cases—that are held at FDIC-insured banks or savings and loan associations.
How Can I Start a Roth IRA or a Traditional IRA?
You can open your IRA at most banks, credit unions, online brokers, or other financial services providers. Fidelity, Charles Schwab, and E*Trade are all brokers that provide IRAs.
Opening an account is as easy as visiting a bank branch or website and filling in a form.
When Can I Withdraw From an IRA?
The best time to withdraw from an IRA is at age 60 and beyond.
If you withdraw before age 59½, you will incur a 10% early withdrawal penalty, in addition to taxes on the withdrawal. There are some exceptions to this penalty for medical expenses, disabilities, first-time home purchases, and other unusual life events.
Generally speaking, the longer you can wait before taking distributions, the more time that money has to grow.
How Is a 401(k) Plan Different From an IRA?
Both 401(k) plans and IRAs provide tax advantages to employees investing for their retirement.
A 401(k) plan is only available through an employer. Contributions are automatically deducted from the employee’s paycheck. Some companies match part of employee contributions.
401(k) plans have higher contribution limits.
An IRA can be set up by anyone who has earned income, regardless of whether they have a 401(k) plan at work.
Most 401(k) plans offer a limited choice of mutual funds and exchange-traded funds (ETFs). An IRA can offer a wider range of funds, stocks, and other securities.
The Bottom Line
IRAs are retirement savings accounts that offer tax advantages. They work a bit like a 401(k), but they don’t require an employer to sponsor them. There are several types of IRAs: traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. There are annual income limitations on deducting contributions to traditional IRAs and contributing to Roth IRAs, so there is a limit on how much tax you can avoid by investing in an IRA.
IRAs are meant to be long-term retirement savings accounts. If you take money out early, you defeat that purpose by diminishing your retirement assets. That’s why money held in an IRA usually can’t be withdrawn before age 59½ without incurring a hefty tax penalty of 10% of the amount withdrawn (in addition to normal taxes owed).
Article Sources
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