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A Brief Introduction to the Individual Retirement Account (IRA)

A Brief Introduction to the Individual Retirement Account (IRA)

The most common retirement investment account is the 401(k), likely because these accounts are set up through employers and completely automated. However, there are many other options for people who want to diversify their portfolio, increase their savings after they have maxed out a 401(k), or who do not have access to an employer-sponsored plan.

One of the key options is the individual retirement account (IRA), which is also a tax-advantaged account. Many different types of IRAs exist, and each comes with its own rules and tax advantages. Before opening an IRA, you should learn about the different types and consider which can best serve your particular needs.

How Does an IRA Work?

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Like a 401(k), an IRA is an investment account. In other words, the money that is deposited into the account is invested in stocks, bonds, and other types of assets. An IRA can earn or lose money depending on the types of investments chosen by the account holder. According to IRS rules, you must have earned income to contribute to an IRA, although there is a spousal version of the account through which you can contribute on behalf of a spouse who does not have earned income.

IRA contribution limits are less than those of 401(k)s. Currently, the traditional IRA has a contribution limit of $6,000 annually, or $7,000 for people 50 and older. Importantly, these contributions can be made even if you contribute to a 401(k) or another workplace savings plan.

Different types of IRAs have different withdrawal rules, but in general, you cannot touch the money in the account until you turn 59 and a half. Withdrawals before this age will incur a 10 percent penalty on top of the tax bill. While this rule has been changed as part of the COVID-19 relief bill, don’t expect this exception to last beyond 2020. IRAs have tax benefits, but the exact rules will depend on the specific type of account you open.

What Are the Most Popular IRA Plans?

Most people who opt for an IRA will open either a traditional or a Roth account. Understanding the difference between these two types of accounts is essential because they have very different tax implications. A traditional IRA works very much like the standard 401(k). Similar to having contributions deducted from your paycheck before taxes, as with a 401(k), contributions to an IRA become a tax deduction. A traditional IRA therefore reduces your taxable income for a given year, similar to a traditional 401(k). Once the money is deposited into the account, it is allowed to grow without being taxed. However, once you start taking withdrawals in retirement, these payments are taxed as ordinary income. Anyone can open a traditional IRA, regardless of income, to achieve a smaller tax bill.

A Roth IRA works differently. You’ll fund the Roth IRA on a post-tax basis, like a Roth 401(k). Because of this, you can withdraw contributions from the account at any time without penalty. However, earnings on those contributions cannot be withdrawn without penalty. While you do not receive an immediate tax benefit for contributing to a Roth IRA, you can later withdraw during retirement without paying any taxes. In the meantime, the money grows tax-free. The downside of a Roth IRA is that it has an income cap at which point you cannot open an account. At the same time, it’s possible to create a backdoor Roth by converting a different account.

Which Other Types of IRAs Should You Consider?

While a traditional and Roth IRA are the most popular choices, other options exist for specific circumstances. For example, as mentioned above, you can open a spousal IRA. This account is owned by the non-working spouse and can be used to basically double retirement savings for a couple.

Another important option is the simplified employee pension (SEP) IRA, which is meant for self-employed workers and small business owners. The SEP IRA works much like a traditional IRA, except the contribution limit is 25 percent of compensation up to $57,000, so it is much more powerful than a traditional account in terms of overall savings. However, the IRS requires small business owners with SEP IRAs to fund their employees’ accounts at the same percentage of annual income that they save for themselves. This can become quite expensive.

Small companies with fewer than 100 employees can also open a savings incentive match plan for employees (SIMPLE) IRA. Business owners who choose this type of IRA will be required to contribute to employee accounts. The benefit of a SIMPLE IRA over a SEP is the ability to put personal money into the account. Like with a traditional IRA, the contributions reduce tax liability for the current year, and the investments grow without taxes. However, taxes are due once withdrawals begin during retirement.