An Individual Retirement Account (IRA) is a retirement savings account set up with a financial institution or brokerage firm that offers tax breaks for those investing income for their retirement. IRAs can be opened by an individual, self-employed individuals and small business owners.
An IRA can help someone gain access to a wider range of investment options compared to a plan given by employers while having tax-deferred or tax-free growth. Some financial experts have also said that an individual may need up to 85% or more of their current income in retirement, and employee savings plans, such as 401(k)s, are now not enough alone to provide for retirement in most cases.
IRAs allow for stocks, bonds and mutual funds to be used to save for retirement and can be used for a wide range of alternative investments when self-directed, including real estate, private placements and tax liens.
The process can also be called an Individual Retirement Arrangement.
Types of IRAs
Different types of IRAs will work better for certain individuals; two of the most well-known include traditional IRAs and Roth IRAs.
- Traditional IRAs allow tax-deductible retirement plan contributions. Withdrawals are taxed at the current tax rate when funds are withdrawn from the account, but any transactions within the account are not taxed. This works best for investors who think their tax rate will go down in retirement. Two types of traditional IRA are Savings Incentive Match Plan for Employees (SIMPLE) IRA, which is similar to a 401(k)plan, and Simplified Employee Pension (SEP IRA), which is for small businesses to set up for employees.
- Roth IRAs, unlike traditional IRAs, do not offer a tax deduction on contributions, but funds withdrawn in retirement are not taxed. This is useful for those who expect to have higher post-retirement income tax levels than at the time of their investment. MyRA, introduced by the Obama administration, is a type of Roth IRA.
It is possible to have both traditional and Roth IRAs, but contributions to both combined may not exceed yearly contribution limits.
Other types of IRAs include:
- Rollover IRAs allow an individual to contribute money that is moved over from other retirement plans. For example, an individual can roll over their money from a 401(k) into an IRA, or from a 403b into an IRA.
- Backdoor Roth is a type of IRA for individuals with high incomes who are priced out of making normal Roth contributions. Essentially, a backdoor Roth is when someone puts money into a traditional IRA, then converts that account to a Roth IRA, and pays the tax bill -- sidestepping the income requirement. In this case, a portion of the converted money may be taxable.
- Self-directed is a specific IRA that allows people to have more options when it comes to individual investments. For example, individuals can choose investments in real estate or a privately-held company, potentially providing a higher ROI. Self-directed IRAs can be either be implemented in traditional or Roth IRA accounts, with the same corresponding income rules.
- Spousal IRAs are for individuals that do not have an earned income. Spouses who do not work can contribute to traditional or Roth IRAs. However, the total contribution amount cannot exceed the working spouse's income, with contribution limits of $6,000 - $7,000 depending on age.
- Inherited IRAs are IRA accounts that are opened when the original owner dies. The rules for handling an inherited IRA are different depending on who is inheriting the IRA, for example, if that person is a spouse or not. Additional contributions cannot be made to an inherited IRA.
How IRAs work
IRAs work differently depending on the type of IRA, the age of the individual and the amount of earned income.
IRAs work by allowing an individual to invest their money in stocks, bonds and additional assets (depending on the type of IRA). An account is opened with a broker or bank, and individuals are allowed to invest only a limited amount of money per year, known as an annual limit. Withdrawal rules do apply, as individuals who withdraw money before a specific age face a penalty and tax bill. Generally, IRAs allow individuals to save no more than $6,000 a year, with an additional $1,000 in catch-up contributions allowed for those over 50 years of age. Penalties of 10% generally apply for withdrawals before the age of 59.5. In many cases, contributions to traditional IRAs are tax-deductible. Starting at age 72, traditional IRA holders are responsible for taking out required minimum distributions (RMDs).
Over time, the Internal Revenue Service (IRS) may change contribution limits, income phaseout and other IRA requirement factors. Individuals may not have the opportunity to earn the stock market rates of return on their retirement contributions.
How to open an IRA
Before opening an IRA, individuals need to decide how much they want to be involved in managing the IRA investments. This will help determine where to go to open an IRA.
IRAs can be opened by a custodian, a financial institution that holds an account's investments and sees to ensure all IRS regulations are adhered to. Custodians that individuals can go to include banks, brokerage firms, mutual fund companies, some life insurance companies and through robo-advisers -- which are websites that make investment recommendations.
If someone wants more options for investments, then going through a brokerage would be a good option. And if someone wants help in managing the account, then a robo-adviser could work. Brokerages tend to offer competitive IRAs. If an IRA is open at a bank, then money will go into a sort of savings vehicle which offers a lower rate of return than in other options.
The setup process is relatively straightforward. Individuals will have to provide information such as their employment details, Social Security number, birthdate and contact information. There is not typically a specific opening fee, although there may be different up-front costs -- such as requiring a minimum amount of input to open the account. Money will also be needed to purchase investments.
Contributing to an individual retirement account
The amount an individual can contribute to an IRA depends on factors such as type of IRA, time, age and spousal ties. In general, the IRS will limit how much money can be deposited in any type of IRA and may adjust the specific amount by year. Individuals can only make contributions if they meet the earned income limits each IRA type sets. Generally, traditional and Roth IRAs have the same contribution limits. Some examples of contribution limits include:
- Traditional IRA - $6,000. $7,000 if age 50 or older.
- Roth - $6,000. $7,000 if 50 or over.
- SEP - the lesser of 25% of compensation or $57,000.
- Simple - $13,500. $16,500 if 50 or over.
Tax filers who are married can jointly contribute up to contribution limits if their combined modified adjusted gross income (MAGI) meets a specified requirement.
IRAs and taxes
Generally, IRAs allow individuals to deduct any contributions on their taxes. In addition, while in the account, gains and dividends aren't taxable. Taxes in an IRA account are handled differently depending on the type of IRA. For example, traditional IRA contributions will reduce an individual's tax bill that contribution year. While Roth contributions are not tax-deductible, investments will grow tax-free. In addition, individuals with Roth IRAs can withdraw their money tax-free when in retirement.
Individuals can be exempted from penalty charges for withdrawing money early in a number of cases. For example, in the case of a first-time home purchase, divorce, unreimbursed medical expenses, education expenses or in disability. If an individual makes an IRA deposit, then changes their mind by the extended due date for the years tax return, then they can withdraw it without penalty as well.
IRA vs. 401(k)
Both IRAs and 401(k)s are used as savings for retirement. They are not exclusive, so individuals can have both an IRA account and a 401(k) at the same time. The main difference between the two types of accounts is that employers will offer employees a 401(k), while an individual can open an IRA. While IRAs have more investment options, a 401(k) allows for larger maximum yearly contributions.
Employers will normally match what employees put into a 401(k) to a point -- normally around 3-10% of the person's salary. If a company matches what they put into a 401(k), then the individual should choose to open a 401(k), however, if they don't offer a match, then an individual should open either a traditional or Roth IRA.
History of individual retirement accounts
IRAs were originally introduced in 1974 as part of the Employee Retirement Income Security Act (ERISA). ERISA was originally restricted to workers not covered by employer retirement plans. The act allowed taxpayers to contribute up to 15% of their annual income each year, or $15,000, and reduce their taxable income by the amount of their contributions. Which option depends on whichever was less. Contributions could be invested in U.S. bonds with 6% interest, annuities or trusts.
In 1981, all working taxpayers under 70 years of age could contribute to an IRA thanks to the Economic Recovery Tax Act (ERTA). The ERTA also raised the maximum annual contribution one could make and allowed a smaller extra amount to be contributed for non-working spouses. A few years later, in 1986, the Tax Reform Act of 1986 phased out deductions from high-income taxpayers covered by employment-based retirement plans.
The Small Business Job Protection Act of 1996 (SBJPA) expanded IRAs more. Namely, limits to contributions for non-working spouses were increased.
The Taxpayer Relief Act of 1997 phased out limits for high-income taxpayers, allowing more taxpayers to make contributions. 1997 also introduced Roth IRAs.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 gave more protection to IRAs in case of bankruptcy. One year later, the Pension Protection Act allowed individuals to charitably give, free of tax, from an IRA.
The Economic Growth and Tax Relief Reconciliation Act of 2001 also expanded the contribution limits of IRAs. In 2010, a provision in the EGTRRA was made to allow people to convert traditional IRAs to Roth IRAs.
The Tax Cuts and Jobs Act of 2018 got rid of the recharacterization of Roth IRA conversions. One year later, the Setting Every Community Up for Retirement Enhancement (SECURE) Act passed. This 2019 act required minimum distributions to begin in the year the IRA holder becomes 72 years of age. The stretch IRA was also cut down on, concerning inherited IRAs. Additionally, inherited IRAs must be distributed within 10 years.