An IRA or individual retirement account is a tax-advantaged retirement account designed to help individuals save for retirement. IRAs were first authorized by Congress in 1974 and were limited to those without pension coverage. The eligibility was later expanded to all individuals including those covered by a workplace retirement plan.
How does an IRA work?
There are two types of IRA accounts, Roth and traditional. The annual contribution limit for IRAs is $6,000 with an additional $1,000 catch-up contribution for 2021. Annual limits are increased on occasion. These limits are in total for all IRA accounts.
The ability to contribute to an IRA is based on having earned income, which means income from employment or self-employment.
If you withdraw the money prior to age 59 ½ there will generally be a 10% penalty in addition to any taxes due. There are some situations where the 10% would not apply.
In addition to annual contributions to an IRA, money from a workplace retirement plan like a 401(k) can generally be rolled over into an IRA account when you separate from your employer.
IRA account holders can invest in a wide range of investments including stocks, bonds, mutual funds, ETFs and others. There are very few types of investments that can be held in an IRA, life insurance policies and certain collectibles are two examples of prohibited investments.
Any investment gains or distributions such as dividends are able to grow tax-free or tax-deferred in the IRA account. There are no taxes on any of the money in the account until it is withdrawn. In the case of a Roth IRA there are no taxes at all if certain rules are followed.
Types of IRAs
Traditional IRA
Contributions to a traditional IRA may be made on either a pre-tax or an after-tax basis. Money in the account is invested on a tax-deferred basis. Withdrawals from a traditional IRA will be subject to taxes at the account owner’s ordinary income tax rate. The exception to this are any contributions made to the account on an after-tax basis, though the account holder will need to keep track of these amounts.
If you or your spouse are covered by a retirement plan, such as a 401(k), from your employer there are income limitations above which contributions to a traditional IRA cannot be made on a pre-tax basis. For 2021, these MAGI (modified adjusted gross income) limits are:
| Filing status | MAGI limits | |
|---|---|---|
Married filing jointly or qualified widow(er) | $105,000 or less | Full deduction |
More than $105,000 but less than $125,000 | Partial, prorated deduction | |
$125,000 or above | No deduction | |
Single or head of household | $66,000 or less | Full deduction |
More than $66,000 but less than $76,000 | Partial, prorated deduction | |
$76,000 or above | No deduction | |
Married filing separately | Less than $10,000 | Partial deduction |
$10,000 or above | No deduction |
Contributions to a traditional IRA can still be made on an after-tax basis for those who are limited or prohibited from making a pre-tax contribution by these income limits. For those who are not covered by a workplace retirement plan, there are no income limitations restricting pre-tax contributions.
Traditional IRA accounts are subject to required minimum distributions (RMDs) once the account holder reaches age 72.
Roth IRA
Contributions to a Roth IRA account are made on an after-tax basis. If all rules are followed, withdrawals from the account will be tax-free on or after age 59 ½. Withdrawals taken before this age could be subject to a 10% early withdrawal penalty. Withdrawals could be subject to taxes if withdrawn prior to meeting the five-year rule from the time of your first Roth IRA contribution. Withdrawals of your own contributions are never subject to taxes or penalties.
Roth IRA accounts are not subject to RMDs allowing them to continue to grow tax-free into retirement.
Roth IRA contributions are subject to income restrictions based on your MAGI. The limits for 2021 are:
| Filing status | MAGI limits | |
|---|---|---|
Married filing jointly or qualified widow(er) | $198,000 or less | Full contribution limit |
More than $198,000 but less than $208,000 | Partial, prorated contributions | |
$208,000 or above | No contributions allowed | |
Single or head of household | $125,000 or less | Full contribution limit |
More than $125,000 but less than $140,000 | Partial, prorated contributions | |
$140,000 or above | No contributions allowed | |
Married filing separately | Less than $10,000 | Contribution is reduced |
$10,000 or above | No contribution |
Those whose contributions to a Roth IRA are limited or prohibited can still contribute to a traditional IRA, most likely this will be on an after-tax basis. Your overall IRA contributions cannot go over the $6,000/$7,000 annual limits.
SEP-IRA
A SEP-IRA is a type of IRA designed for the self-employed or small businesses with a few employees. SEP stands for simplified employee pension.
With a SEP-IRA, contributions are deductible, but can only be made by the employer. No employee contributions are allowed. For 2021 contributions can be made up to 25% of compensation, with a maximum contribution of $58,000.
SEP-IRAs are generally available at most standard custodians and investments can be made in the same types of vehicles as with a traditional or Roth IRA.
There is no Roth option available for a SEP. If there are employees eligible under the plan, employers must make the same percentage contribution for employees as they do for themselves.
SIMPLE IRA
SIMPLE IRAs are plans designed for small businesses with 100 or fewer employees. They can be used by self-employed solopreneurs as well. SIMPLE stands for Savings Incentive Match Plan for Employees.
SIMPLE IRAs are easy to open for employers and have minimal paperwork requirements when compared with a 401(k). Employers are required to make either a matching contribution or a contribution for all employees regardless of whether or not they contribute.
Employee contribution limits for 2021 are $13,500 with an additional $3,000 catch-up contribution for those who are 50 or over. Each employee has their own account and investments can either be made into a pre-selected menu of options or based on the employee’s preference if no set menu is offered.
One quirk of the SIMPLE IRA is that the money cannot be rolled over to another plan for at least two years after it was initially opened if the employee leaves the company. The exception is into another SIMPLE IRA plan.
Pros and cons of an IRA
Pros of an IRA include:
- The main benefit of an IRA account is the tax-advantaged nature of the accounts. Investments are allowed to grow either tax-deferred or tax-free until withdrawn in retirement.
- Roth and traditional options allow for tax diversification in your retirement savings.
- IRAs are a way to keep money in a 401(k) or other retirement tax-deferred or tax-free by rolling this money over when leaving your employer.
Cons of an IRA include:
- Low limits on the amount that can be contributed each year.
- They can be subject to taxes or penalties upon withdrawal.
- Income limits can impact your ability to make pre-tax contributions to a traditional account or to contribute to a Roth IRA at all.
How to open an IRA
IRAs can be opened at virtually all brokers, most mutual fund companies, banks and some other financial institutions. Most robo advisors offer IRA accounts as well. You will need to complete the appropriate forms; this can often be done online.
If you want to hold some types of alternative assets in your IRA, SEP-IRA or other types of self-employed retirement accounts you will likely need to open an account with a self-directed retirement platform. Examples of the types of assets that might need this type of account are rental real estate, cryptocurrencies, livestock, private equity among others.
FAQs
Is an IRA the same as a 401(k)?
These two types of retirement accounts are completely different. A 401(k) is a retirement plan that is offered by an employer with the opportunity for eligible employees to contribute to the plan. The plan may offer an employer matching contribution and the ability to take a plan loan may be offered.
The annual 401(k) contribution limits are considerably higher than for an IRA at $19,000 and $26,500 for those 50 or over for 2021. A 401(k) plan generally has a set investment menu from which participants can choose in directing their investments.
An IRA is opened by the account holder. The contribution limits are much lower. The range of investments from which account holders can choose is generally much larger.
When can I withdraw from an IRA?
Withdrawals from an IRA can be made at any time. However, if you are under age 59 ½ you may be subject to a 10% penalty on top of any taxes owed. There are exceptions to this, it is best to check with the account custodian or your financial advisor.
Can you lose money in an IRA?
Any investment gains or losses inside of an IRA account will depend upon how you invest the money. If the investments you choose decline in value, you could certainly lose money.
Summary
An IRA can be an essential tool in your efforts to save for a comfortable retirement. It's important to understand the rules surrounding an IRA and the different types of IRA accounts. It’s important to consider your situation and overall financial planning goals in determining the best way to use IRAs.