An Individual Retirement Arrangement - popularly known as an IRA - is an important retirement savings vehicle, especially for people who are not covered by a retirement plan at work.
Knowing the different kinds of IRAs and how they work can help you decide which investment vehicles take you toward a more comfortable retirement.
This comprehensive guide covers key aspects involved in choosing and using an Individual Retirement Arrangement (IRA).
The topics range through all stages of having an IRA, from setting one up through making contributions to eventually taking your money out of the plan.
What is an IRA?
An Individual Retirement Arrangement, or IRA, is a retirement savings account that you as an individual can set up to defer certain tax obligations until retirement.
The main advantage of an IRA is that your money is allowed to grow tax-free and, in many cases, you can manage your eventual withdrawals from the plan so they come at a time when you are in a lower tax bracket.
So IRAs offer certain tax advantages, but they also impose certain restrictions.
Knowing about those advantages and restrictions should help you decide whether to open an IRA and which type of IRA is best for your situation.
How Does an IRA Work?
An IRA differs from an employee-sponsored retirement plan like a 401(k) in that it is an individual plan in your name rather than a collective plan covering a group of employees. This gives you greater control over how the plan is managed.
The main characteristic of an IRA is a trade-off:
You commit your money until you reach retirement age (or something close to it) in exchange for certain tax breaks.
Tax breaks are intended to encourage people to save for retirement and also to help investments within an IRA grow.
The exact nature of those tax breaks depends on the type of IRA. There are two basic types:
- Traditional IRAs
Main Characteristic: With a traditional IRA, you can deduct your contributions to the plan and defer paying taxes until you start to draw money out of the plan.
- Roth IRAs
Main Characteristic: With a Roth IRA, you don't get an initial deduction for your contributions, but then qualified distributions taken out of the plan later on are tax-free.
[These IRAs are generally set up independent of the workplace. However, two types of IRAs - SEP and SIMPLE IRAs - are designed to work within the context of small businesses. Details on SEP and SIMPLE IRAs are explained below.]
Characteristics all IRAs share
Though the exact workings of an IRA depend on which type it is, they all have some general characteristics in common:
- Money may be put into the IRA by the owner of the account (or, in the case of SIMPLE and SEP plans, by the employer of the account owner).
- IRA owners get a break on their income taxes in exchange for putting money in the plan. In some cases, this comes when the contribution is made and in other cases it's when money is taken out of the plan.
- There are limits to how much you can put into an IRA each year.
- Investment earnings (including income and capital gains) on money within the IRA is not taxed.
- Money cannot be taken out of an IRA until you reach age 59½. Withdrawing money earlier than that, except in limited hardship circumstances, results in a 10% penalty on top of any income tax owed on the withdrawal.
One characteristic that differs by IRA type - when money is taxed
Depending on the type of IRA, money is either taxed before it goes into the IRA or when you take it out. However, in either case a key advantage is that, while money is in the IRA, its investment growth is not slowed down by taxes.
Before getting into the details of how all this works for each type of IRA, a good starting point is to discuss how money can go into and be taken out of an IRA.
Understanding how that works helps explain the differences between the different types of IRA, and how they might affect you.
Who Can Put Money Into an IRA?
A great thing about IRAs is that most people who have earned income can put money into an IRA. There used to be an age limit of 70½ for making contributions to a traditional IRA, but this has been repealed.
Income restrictions can limit IRA contributions
These restrictions can apply if you make too little income or too much.
- Minimum income limits
One restriction is that you can't make a contribution to an IRA that exceeds your earned income for the year.
If you are married and file joint tax returns, you both can contribute to an IRA even if only one of you earns income. However, your combined contributions cannot exceed your combined income.
- Maximum income limits
If either you and/or your spouse is covered by a retirement plan at work, your ability to contribute to an IRA may be restricted based on your income.
These restrictions may reduce or even eliminate how much you are able to put into an IRA. The way these restrictions are applied varies depending on your income and your marital status, so check IRS guidelines for details.
- Contribution amounts
As long as you are within the minimum and maximum income guidelines, the amount you can contribute to an IRA depends on the type of IRA.
The specific contribution limits in each case is described in subsequent sections of the different types of IRA. These include catch-up contributions, which for most IRAs allow people aged 50 or older to contribute additional amounts each year.
It is possible to have more than one IRA. However, the annual contribution limits apply to the total of all your IRA contributions.
Taking Money Out of an IRA
Once you put money into an IRA, you are not supposed to take it out until you reach age 59½.
There are some exceptions to this rule in the case of disability or to pay certain medical or higher education expenses. Also, qualified first-time home buyers may be able to take up to $10,000 out of an IRA to put toward the purchase of a home.
If you are younger than 59½ and do not qualify for any of the above exceptions, any withdrawals you make from an IRA will be subject to a 10% penalty. This is on top of any ordinary income taxes you owe on the amount taken out.
Even if you meet the requirements for taking money out of an IRA without a penalty, the amount you take out may be subject to income tax. Roth IRAs are an exception to this. (See the section on Roth IRAs for more details).
To a large extent, you can vary the timing of when you take money out of an IRA and how much you take. This allows you to manage the tax liability from those distributions to a large degree too.
However, you cannot put off paying taxes on the money that goes into your IRA forever.
In the case of Roth IRAs, you pay taxes on that money up front. With other IRAs, you are required to start taking out a certain amount of money each year once you reach a certain age. Those withdrawals are subject to income tax.
Why is an IRA a Good Deal?
As noted previously, IRAs do not allow you to escape taxation forever. You either have to pay taxes on your money before it goes into the IRA or as it comes out.
Since you have to pay taxes at some point, what makes IRAs such a good deal?
The key is that, while your money is in the IRA, the money it earns by being invested can compound without taxes being taken out from year to year.
Over time, this ability of investment earnings to compound without year-to-year taxation makes a big difference.
Advantages of Tax-Free Investing - an Example:
Consider what could happen to $5,000 over 30 years if you are in a 30% income tax bracket and are able to earn 8% a year in investment returns.
In an IRA, you'd either pay taxes on that $5,000 up front or you'd pay taxes on the value of that money when you took it out of the IRA in retirement.
In either case, compounding in an IRA at 8% a year for 30 years would allow that $5,000 to grow to $35,219.30 after taxes.
However, if you simply invested that money outside of an IRA, you would not only pay taxes on the $5,000 up front, but your investment earnings would be subject to taxation from year to year.
Because of this, even after earning 8% for 30 years, that $5,000 would only be worth $17,946.74 after taxes. That's barely half what it would have grown to in an IRA.
So, while an IRA may not allow you to escape taxation altogether, it can reduce the impact of taxes on your money. That's what makes an IRA a good deal.
Now let's look at some specifics on how that deal works in different types of IRAs.
What is a Traditional IRA and How Does It Work?
As the name suggests, a traditional IRA is the original type of IRA plan. It allows account owners to put off paying taxes on money they put into the IRA until they retire.
How does that work?
If you meet the eligibility requirements as discussed below, you can contribute up to $6,000 a year to an IRA. If you are aged 50 or older, you may also put in an additional $1,000 catch-up contribution.
Those contribution limits are subject to change in the future, so check the limits each year you plan to make a contribution.
Your contributions are fully deductible from your taxable income. Also, your investment earnings on money in your IRA are not taxed from year to year.
The money in your IRA is not taxed until you start to take money out of the plan. You can do that once you reach age 59½.
Any withdrawals you take once you reach that age are included in your income and taxed at your ordinary income tax rate. Up to that point, your money can benefit from investment growth without taxation.
There is a penalty if you take money out of a traditional IRA before you reach age 59½. In addition to paying ordinary income tax on the amount you withdraw, you would have to pay a 10% penalty.
Once you reach age 59½, you can take as much or as little out of your IRA as you want each year. However, once you reach a certain age, you are required to start taking money out of your IRA and paying taxes on that money. These are called required minimum distributions (RMDs).
The rules for RMDs have changed, so they depend not just on your age, but when you reached certain age levels:
- If you turned age 70½ prior to December 31, 2019, you must start making RMDs as of the tax year in which you turned that age.
- If you turned age 70½ after December 31, 2019, you don't have to take RMDs until the tax year in which you turn age 72.
Who can put money into a traditional IRA?
Generally speaking, as long as you or your spouse (if you file joint tax returns) had taxable income during the year, you can put money into an IRA.
However, if you or your spouse are covered by another retirement plan at work and earn a high income, the amount you can put into an IRA may be limited. See IRS guidelines for how these limits apply to your situation and your income.
What is a Roth IRA and How Does It Work?
Unlike contributions to a traditional IRA, contributions to a Roth IRA are not tax-deductible. However, you do not have to pay taxes when you take money out of a Roth IRA as long as you meet certain requirements.
You can contribute to a Roth IRA at any age. The contribution limit is currently $6,000 a year, though that amount may change over time.
If you are aged 50 or older, you can put in an additional $1,000 in catch-up contribution.
These contribution amounts may be limited if you or your spouse is covered by a retirement plan at work. These limitations depend on your filing status and your income, so see IRS guidelines for how they apply to your situation.
Since Roth IRA contributions are not tax deductible, why are they a good deal?
The reason is that, for as long as the money is in the Roth IRA, it can grow free of taxes.
Once you reach age 59½, you can then take money out of your Roth IRA without including it in your taxable income, as long as it has been at least five years since you first contributed to the plan. There is a 10% penalty if you take money out of a Roth IRA and do not meet those requirements or qualify for an exception.
Unlike traditional IRAs, Roth IRAs do not have required minimum distributions. The advantage of this is that it allows you to keep your money invested tax-free in the plan for as long as you like.
What is a SEP IRA and How Does It Work?
A Simplified Employee Pension (SEP) is an employee benefit plan designed for small employers. This includes people who are self-employed.
It is a form of IRA because it involves the employer setting up an IRA account for each eligible employee. However, instead of employees contributing to their own IRAs, the employer does it on their behalf.
To be eligible for SEP IRA contributions, an employee must be at least 21, have worked for you in at least three of the past five years, and have earned at least $600 in compensation from you in the current tax year.
An advantage of a SEP IRA is that it allows people who run a small business to contribute much more than the normal IRA limits on their own behalf and on behalf of their employees.
The contribution limits for a SEP IRA are the lesser of:
- 25% of the employee's compensation
The disadvantage may be that having a SEP plan requires the business owner to contribute on behalf of all eligible employees, except those covered by negotiated union benefits and nonresident alien employees who have received no U.S. compensation from the company.
From a tax standpoint, SEP IRAs work much the same way as a traditional IRA. The employer gets to deduct contributions as they go into the plan, and distributions are taxed as income to the account owner as they come out of the IRA.
As with other IRAs, there is a 10% tax penalty for distributions taken before the age of 59½.
What is a SIMPLE IRA and How Does It Work?
A Savings Incentive Match Plan for Employees, or SIMPLE plan, is another form of retirement plan for small employers.
It can work as sort of a cross between an IRA and a 401(k) plan.
As with a 401(k) plan, both the employer and the employee can contribute on the employee's behalf. However, to simplify administration, the money can go into individual IRAs set up on each employee's behalf rather than into a centralized employee benefit fund.
Companies with no more than 100 employees who received at least $5,000 in compensation from the company in the previous year can have a SIMPLE plan.
Employees can contribute up to $13,500 of their salaries to a SIMPLE plan. Those who are aged 50 or older can also contribute an additional $3,000 in catch-up contributions.
Employers have a choice of how they contribute to these plans. They can either set up the plan to match the employee's contribution for up to 3% of the employee's compensation, or they can contribute up to 2% of the employee's compensation regardless of whether or not the employee contributes to the plan.
However they set up their contributions, employers must make those contributions on behalf of all eligible employees.
Eligible employees are those who made at least $5,000 from the company in any two years prior to the current year, and are expected to earn at least $5,000 in the current year.
There is an exception to the employer contribution requirement for employees covered by negotiated union benefits and nonresident alien employees who received no U.S. compensation from the company.
From a tax standpoint, SIMPLE IRAs work much the same way as a traditional IRA. The employer and employees each get to deduct their contributions as they go into the plan, and distributions are taxed to the account owner as they come out of the IRA.
As with other IRAs, there is a 10% tax penalty for distributions before the age of 59½.
Choosing Between a Traditional and a Roth IRA
When setting up an IRA on their own behalf (as opposed to as an employee benefit plan), an individual has the choice between a traditional and a Roth IRA.
That choice comes down to whether to pay taxes on your money before it goes into the plan or to deduct your IRA contribution and pay taxes as money comes out of the plan.
If the tax rate now and when you take money out of the plan were the same, it should make no difference in the long run whether you pay taxes up front or later. However, if you expect your tax rate to be different in retirement than it is now, it could guide your choice between a traditional and a Roth IRA.
For example, a young person just starting a career might not earn much and thus be in a low tax bracket. It might make sense to pay taxes now rather than later on. That would make a Roth IRA the better choice.
In contrast, a person in their peak earning years may be in a higher tax bracket than they expect to be in once they retire. In that case, paying taxes later with a traditional IRA might make more sense.
The following chart summarizes some of the key distinctions between traditional and Roth IRAs:
When can you contribute?
You can contribute at any age when you have taxable compensation, though income limits apply.
|Traditional IRA||Roth IRA|
|How much can you contribute?||$6,000 per year, or $7,000 if you are aged 50 or older||$6,000 per year, or $7,000 if you are aged 50 or older|
|Are contributions tax-deductible?||Yes, though the deduction may be limited for high-earners if you or your spouse are covered by a retirement plan at work||No|
|Are investment earnings taxable from year to year?||No||No|
|When can you withdraw money without penalty?||Age 59 ½||Age 59 ½, but withdrawals also must be at least five years after the IRA was established.|
|Are qualifying withdrawals taxable?||Yes||No|
|Are there required minimum distributions?||Yes, you are required to start taking distributions once you reach age 70 ½||No, as long as you are the original owner of the IRA|
Key selection factors:
Given the differences between Roth and traditional IRAs, consider these factors when deciding which is best for you:
- Current tax status
If you are in a high tax bracket, you are likely to benefit most from a traditional IRA that lets you take the tax deduction now. You will have to pay tax on withdrawals later on, but you may be in a lower tax bracket once you retire.
If you are currently in a low tax bracket, a Roth might be best because it will allow you to avoid paying tax on withdrawals later on, when you may be in a higher bracket.
For the tax reasons explained above, Roth IRAs are often recommended for younger adults on the assumption that they are likely to be in lower tax brackets early in their careers.
Roth IRAs can also make the most sense for workers at or close to retirement age who still consider it worthwhile to make long-term retirement investments.
- Retirement funding
If your retirement funding looks like it will be ample enough that you wouldn't spend all of the required distributions from a traditional IRA, you might do better with a Roth IRA so more of your money could continue to benefit from tax-free growth in your retirement years.
Investing an IRA
IRAs can be invested in a wide range of vehicles, including mutual funds and individual stocks and bonds.
Mutual funds are a good way to get professional management and diversification with even a relatively small amount of money. As you accumulate a larger amount in your IRA, building a portfolio of individual securities might also become an option.
Because IRAs are intended for long-term retirement savings, it is generally a good idea to have some portion of your IRA in growth investments like stocks, especially when you are younger.
Then, as you approach retirement age, you might shift more of your IRA into conservative investments like short-term bonds, cash equivalents or even savings accounts. These provide the stability and liquidity you will need when you start taking money out of the plan in retirement.
Choosing Where to Open an IRA
IRAs are provided by a wide range of financial institutions, including banks, brokerage firms and insurance companies.
It makes sense to decide how you will want to invest your IRA before you choose where to open it. That way you can choose a firm that has the investment products to meet your needs.
Ideally, you should find a firm with a wide range of product offerings. This will give you the flexibility to change your investments as your needs change.
Always pay close attention to all fees before choosing an IRA provider. These fees may include trading commissions, account maintenance fees, fund management fees and sales loads. While you can't control the returns your investments will earn, you can control the fees you pay.
Your IRA should prove to be very important to you for many years to come. That makes it well worth the time it takes to choose a provider carefully.