An individual retirement account (IRA) is a financial account that allows you to save for retirement through tax-deferred investments. Because some types of IRAs offer tax-free growth, savings in this type of account could grow faster than in a taxable account. Other IRAs enable tax-free contributions, which could reduce account owners’ income tax burden. These tax advantages can provide valuable financial security for individuals when they retire.
While all investment opportunities carry the risk of loss, IRAs also bring potential opportunities to grow wealth passively and make other investment choices. Understanding how an IRA works can help you decide whether this investment option fits your financial goals.
What Is an IRA?
The simplest IRA definition is that it is a personal account that allows individuals to save for retirement on a tax-deferred basis. Individuals can open an IRA through a financial institution that has received approval from the Internal Revenue Service (IRS) to offer these accounts, such as:
- Banks
- Investment companies
- Brokerage firms
- Insurance firms
- Savings associations
- Loan associations
IRAs come in several types and allow various investments, giving account holders multiple choices for investing for their future. Some types of IRAs allow tax-deductible contributions, while others enable tax-free deductions. With numerous options to suit your personal investment goals, you have freedom in saving for retirement with an IRA.
What Does an IRA Do?
The purpose of an IRA is to create a retirement account that compounds funds faster than in a taxable account. Depending on the type of account, IRA funds may compound tax-exempt. IRA owners can also generate additional earnings on interest, capital gains, and dividends. An IRA either allows tax-free interest or defers taxes until you take withdrawals. You generally cannot make withdrawals before age 59 ½ without incurring a 10% tax penalty on the amount withdrawn, but there are a few exceptions, which we cover in the next section.
The two main types of IRAs provide different benefits. A traditional IRA brings the advantage of tax deferral, allowing the account holder to reduce their taxable income while growing their income for retirement. Roth IRAs allow tax-free withdrawals and earnings. IRAs also open several investment opportunities, enabling account holders to use their tax-advantaged funds to generate more revenue.
How Does an IRA Work?
Individuals interested in opening an IRA can choose from several types of accounts, each with its own advantages and requirements. However, all IRA types work in essentially the same way, with account owners taking the tax advantage either when they make contributions or when they take distributions.
Account owners make tax-deferred contributions to a traditional IRA, meaning the interest and dividends from the account are not part of the owner’s yearly income, and the contribution reduces their current tax year liability. When an account owner begins taking distributions or withdrawals from a traditional IRA, they pay taxes on their gains.
Investments in a Roth IRA are after-tax, but distributions or withdrawals are tax-free. Any funds within a Roth IRA will not constitute a tax liability.
IRA account holders benefit from the tax advantage when they make contributions or take distributions. The typical age for making penalty-free withdrawals is 59 ½. Some exceptions for taking early deductions include withdrawing a certain amount for:
- A first-time home purchase
- Qualified higher-education expenses
- Medical expenses
- Disabilities
- Unusual life events, such as military service
Early distributions outside these exceptions are subject to taxes and a 10% early withdrawal penalty. The longer you wait to take distributions, the more time the money has to compound and grow.
While the IRS specifies investment limits or which types of investments cannot be made using IRA funds, account holders have various investment options depending on the account custodian. The types of investments you can make with IRA funds include:
- Real estate
- Mutual funds
- Stocks
- Bonds
- Exchange-traded funds
- Various private investments
What Is the Difference Between an IRA and a 401(k)?
Besides IRAs, another primary vehicle for saving for retirement is the 401(k). This retirement saving method is common. There were around 60 million active participants with 401(k)s in 2020, and millions more retirees and former employees. Knowing the differences between these two accounts can help you make the best decision for your wealth management goals.
The primary difference between these types of accounts is that a 401(k) is employer-sponsored, with funds automatically contributed from an employee’s paycheck, while an IRA is an individual plan. Using both of these resources together can further prepare you for retirement.
The retirement account an individual chooses to open depends on their situation and goals. Both 401(k)s and IRAs are tax-deferred retirement accounts, so contributions are either pre-tax or after-tax. Yet the accounts have several differences:
- Employer involvement: Individuals must open an IRA on their own. On the other hand, an employer may choose to offer employees a 401(k) and make pre-tax contributions up to a certain percentage of the account holder’s income. Often, an employer offers a contribution match up to a certain percentage of the employee’s contributions.
- Investment options: 401(k)s come with far fewer investment options than IRAs. The employer typically selects a group of mutual funds in which the account holder can invest.
- Contribution limit: The IRS imposes higher contribution limits on 401(k)s than on IRAs.
What Are the Types of IRAs?
Each type of IRA has unique advantages depending on the owner’s situation and goals. The IRS also taxes IRA funds differently depending on the type of account. Some individuals might prefer their IRA contributions taxed at a particular time to maximize tax benefits. Here are the different types of IRAs and how the IRS handles taxes for each:
1. Traditional IRA
With a traditional IRA, contributions are made pre-tax and are tax-deferred. Investors may also be eligible to receive a tax deduction for the year they contribute. At age 72, traditional IRAs are subject to required minimum distributions, and failing to take these distributions may result in a tax penalty of 50% of the required amount.
The IRS deducts taxes for funds in a traditional IRA when the owner takes a distribution. Distributions are taxed according to the account owner’s tax bracket at the time of withdrawal. Account owners can generally begin taking penalty-free distributions at age 59 ½.
2. Roth IRA
Contributions to a Roth IRA are after-tax. Generally, individuals expect their income to increase over the years, so they might prefer to pay less in income taxes earlier and let the Roth IRA grow tax-free. Additionally, Roth IRA owners do not need to take required minimum distributions at age 72.
Because contributions to a Roth IRA are made with after-tax dollars, individuals pay taxes upfront. Account owners do not receive a tax deduction in the year they contribute. However, withdrawals, earnings, and other qualified distributions are tax-free if made at the right time.
3. Rollover IRA
The rollover IRA allows individuals to move funds from an employer-sponsored retirement account like a 401(k) into a traditional IRA to avoid early withdrawal fees. The IRS taxes withdrawals from this type of IRA as regular income, just as with a traditional IRA.
If an account owner rolls funds from a 401(k) to an IRA, taxes are only due when they withdraw funds from the IRA. However, individuals have 60 days to deposit the funds from a 401(k) into an IRA, or they become taxable.
4. Backdoor IRA
A backdoor Roth IRA is a Roth IRA converted from a traditional IRA. Most backdoor IRAs are converted from 401(k) rollover IRAs.
Because qualification for a typical Roth IRA is based on an individual’s modified adjusted gross income, individuals who earn too much to contribute to a regular Roth IRA account can also use backdoor IRAs. In these cases, individuals deposit funds in a traditional IRA and convert the account into a Roth IRA. Backdoor IRAs can also be done through a trustee-to-trustee transfer, although this is less common.
When an individual converts a traditional IRA into a Roth IRA, the IRS deducts taxes on the amount transferred.
5. Self-Directed IRA
With a self-directed IRA, owners have more flexibility to invest in real estate, privately-held companies, and hard assets like gold. However, IRS rules restrict account holders from investing in the riskiest investment types, such as life insurance and collectibles.
Self-directed IRAs are either traditional or Roth accounts. The IRS handles taxes the same for a self-directed IRA as for an account managed by a custodian.
6. Spousal IRA
The IRS allows non-working and working spouses to open their own IRA as long as the couple files taxes jointly and has taxable compensation. The non-working spouse’s contributions must not exceed the couple’s joint taxable income or twice the annual contribution limit. Spousal IRAs can also be either traditional or Roth IRAs and are taxed accordingly.
7. Inherited IRA
When an IRA owner dies, an individual can inherit the account and its funds. Tax treatment for inherited IRAs is the same as typical IRAs, whether traditional or Roth IRAs.
Who Is Eligible for an IRA?
Anyone with earned income can open an IRA, whatever their age. However, different account types have contribution eligibility requirements. For example, an individual’s ability to make a full contribution to a Roth IRA depends on their income and tax filing status.
The age at which an individual can withdraw from an IRA also depends on the type of account. Most IRAs allow penalty-free distributions starting at age 59 ½.
Required Minimum Distributions
In addition, required minimum distributions (RMDs) may apply depending on the type of account:
- Traditional IRAs: Traditional IRAs require RMDs beginning at age 72. The IRS calculates the RMD for the year by dividing the account balance as of December 31 of the previous year by the account owner’s distribution period or life expectancy.
- Roth IRAs: There are no RMDs associated with Roth IRAs.
How Do You Contribute to an IRA?
To contribute to an IRA, owners and their spouses can link the IRA to their bank account and contribute automatically on a set schedule. This process can be accomplished online through the financial institution, investment company, or brokerage firm through which the individual has the IRA. Many companies and institutions allow individuals to make contributions or investment choices directly from their computers or smartphones.
While contributing to an IRA, knowing and sticking to the applicable contribution limit is essential. Individuals with an IRA can contribute the yearly maximum the IRS allows depending on their circumstances. For instance, IRA contribution limits for traditional IRAs can change yearly. A person may also be able to deduct their contributions to a traditional IRA depending on their income and whether they have an employer-sponsored retirement plan.
In contrast, Roth IRA contribution limits depend on an individual’s filing status and income. Those with incomes higher than the limit for their filing status will face reduced contribution limits. Contributions to Roth IRAs are not tax-deductible.
An excess IRA contribution may occur if an individual contributes more than the IRS limit or makes an improper rollover contribution. The IRS taxes excess contributions at 6% per year for as long as the extra amount remains in the account.
Why Should You Invest in an IRA?
Investing in an IRA is a decision that individuals should weigh carefully alongside their financial goals and personal situation. Some potential downsides of IRAs include the following:
- IRAs have a relatively low contribution limit compared with the limit for 401(k)s.
- Early withdrawal penalties could make these accounts problematic for individuals wanting to use the funds before they turn 59 ½.
- RMDs for traditional IRAs prevent your funds from compounding throughout your entire life.
However, investing in an IRA can also provide account owners with several benefits.
1. An IRA Can Contribute to Your Net Worth
Funds in an IRA grow protected from taxation. Any contributions, interest, capital gains, and dividends an account owner makes will continue to grow tax-free.
Depending on the type of IRA an individual chooses, they may be able to lessen their tax burden significantly. For example, someone might open a traditional IRA if they think they’ll be in a lower tax bracket after retirement since these funds are taxed upon withdrawal. This system can help IRA owners accumulate more wealth faster.
Because the funds in an IRA also contribute to an individual’s net worth and grow tax-deferred, they can help the owner increase their net worth. Having a higher net worth can be beneficial in several scenarios, such as purchasing a house, increasing your credit score, or obtaining a loan.
2. An IRA Can Build Passive Income
Investors can leverage an IRA to build passive income through multiple avenues. In addition to traditional investments like mutual funds, stocks, and bonds, investors can use IRA funds to invest in real estate. With a self-directed IRA, you can use your expertise to purchase commercial or residential properties and earn income through real estate investing.
3. An IRA Belongs Exclusively to the Owner
With a 401(k), the employer can decide which investment opportunities to offer. However, the funds in an individual’s IRA are entirely theirs, within IRS guidelines. The account owner can determine which investments to make and keep their funds even if they switch jobs. With a wide array of investment options, an IRA can offer numerous possibilities for growing wealth.
How Do You Open an IRA?
Investors can open an IRA in a few steps, although the process varies slightly between providers and institutions.
1. Research Your Options
The first step in investing in an IRA is to research your account options thoroughly and compare them to your needs. Consider your age, filing status, and income, along with your goals for the future.
2. Choose Where to Open Your IRA
Various financial institutions and brokerage firms offer different kinds of IRAs. If you want a customized or hands-on approach, you might decide to get help from a financial advisor or other wealth management professional. Consider the level of service you wish to receive and your own investing expertise.
3. Open Your Account and Fund Your IRA
This process varies between providers, though you can generally expect to fill out an application and provide information like your Social Security number and employment information. Name any beneficiaries of your account as you set it up.
You can often move funds directly from your bank account into your IRA or complete a rollover. Remember not to exceed the contribution limits that apply to you.
Can You Have More Than One IRA?
Since IRAs have an annual contribution limit, you might wonder if you can invest more by opening multiple IRAs. While you can have as many IRAs as you’d like, you cannot contribute more than the annual contribution limits across all IRA accounts. The total contribution limit for 2022 is $6,000 or $7,000 if you are older than 50. The additional $1,000 allowed for older individuals is known as a “catch-up” contribution.
For Roth IRAs, filing status and income may reduce the limit.
The more you invest in multiple IRAs, the more complicated contributions could become. Opening numerous accounts could also raise the amount you pay in annual maintenance fees, depending on where you open them.
Opening multiple IRAs won’t allow you to invest more, but this wealth management strategy can still offer some benefits. The pros of having multiple IRAs include:
- More tax advantages: If an individual has a traditional and Roth IRA, they gain the tax and withdrawal benefits of each type of account.
- More investment opportunities: Some investors use one IRA to pursue passive investments and another to manage funds actively.
- Multiple beneficiaries: Opening multiple IRAs also allows investors to name numerous beneficiaries of their funds.
- Higher contributions for couples: Married couples can open multiple IRAs, including a spousal IRA, which raises their contribution limit to double the annual limit or the amount of their joint taxable income, whichever is less.
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