An individual retirement account (IRA) is a perfect way to supplement a work-based retirement vehicle. Individual taxpayers can open either a traditional individual retirement account (IRA) or a Roth IRA. For 2022, annual contributions to either type of account max out at $6,000 per year, $7,000 for those 50 or older. For 2023, the maximum contribution allowed rises to $6,500 (and $7,500 for those 50 or older).
Only the traditional IRA allows a tax deduction when it's opened. It also has no income restrictions limiting who can open one, though the ability to deduct contributions can be limited for those with a retirement plan at work (or a spouse who has one). Finding further information on the traditional IRA isn’t difficult, but a few important factors aren’t overly apparent. Below are five.
- An IRA is an investment vehicle that earns money tax-free until funds are withdrawn.
- The IRS allows taxpayers to deduct the amount of their traditional IRA contributions from their taxes.
- An IRA can hold equities, bonds, real estate, and other investments.
1. There Are Limits on Investments
An IRA is a type of investment vehicle that earns money tax-free until funds are withdrawn and is not an actual investment. For example, the custodian—the financial company that offers and oversees the traditional IRA—will also offer a choice of investments varying in return and risk, such as Treasury bills, money market funds, mutual funds, stocks, and bonds.
You can't invest in just anything, however. Certain types of investments are prohibited from being in IRAs, such as life insurance and antiques or collectibles.
2. The Beneficiary Form Needs to Be Kept Updated
The beneficiary form tells the custodian what to do with the funds should the account holder die. Without the form, loved ones run the risk of not receiving the money quickly or in full. This form also needs to be kept updated, especially if the account holder goes through a divorce or other major life changes.
3. There Are Mandatory Withdrawals
Not all retirees need to rely on an IRA for living expenses. Unfortunately, because the IRS imposes required minimum distributions (RMDs), account holders must begin withdrawing money from their traditional IRA generally by April 1 of the year following the year in which they turn age 72 (or 70½ for individuals who reached that age during 2019 or in a prior year).
Failing to do so results in hefty tax penalties—50% for every dollar not withdrawn. This is one area where Roth IRAs are a better alternative—they have no RMDs until the account holder dies.
4. No Borrowing Is Allowed
Some retirement plans allow short-term loans, but the traditional IRA isn’t one of them. Borrowing from a traditional IRA incurs taxes at the account holder's income tax rate, possibly on the entire value of the IRA, if the account is pledged as collateral. According to the IRS, "If the owner of an IRA borrows from the IRA, the IRA is no longer an IRA, and the value of the entire IRA is included in the owner's income."
5. Real Estate Is a Valid Holding
An IRA doesn’t have to hold only equities, bonds, and other Wall Street-type investments. The account can hold real estate, too. The catch is that the real estate has to be a business property; the account holder can’t purchase a second home or pay off a current home. A house can be bought and flipped as an investment property.
The IRS has strict rules regarding real estate in an IRA. Because of the higher dollar value and the less liquid nature of real estate, this option is only for the more sophisticated investor and requires having a self-directed IRA (SDIRA), a type that allows you to have a wider range of investments. Talk to the appropriate experts before considering adding real estate or opening an SDIRA.
The Bottom Line
Traditional IRAs offer a great chance to save for retirement, but several details and restrictions aren't generally known, such as accessibility of funds and what is and isn't a proper investment within the account.