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What is an 'Individual Retirement Account - IRA'

An individual retirement account is an investing tool individuals use to earmark funds for retirement savings. There are several types of IRAs as of 2018: traditional IRAs, Roth IRAs, SIMPLE IRAs and SEP IRAs. Sometimes referred to as individual retirement arrangements, IRAs can consist of a range of financial products such as stocks, bonds or mutual funds. A self-directed IRA is a type of traditional or Roth IRA that allows investors to make all of the investment decisions for their account and affords access to a broader range of investments, such as real estate, private placements and tax liens.

Breaking Down 'Individual Retirement Account - IRA'

Individual taxpayers establish traditional and Roth IRAs, while small-business owners and self-employed individuals establish SEP and SIMPLE IRAs. These accounts are generally set up through a brokerage. You can find some of the best places to open an account with Investopedia's list of the best brokers for IRAs

Traditional IRAs

In most cases, contributions to traditional IRAs are tax-deductible. If someone contributes $5,500 to their IRA, for example,they can claim that amount as a deduction on their income-tax return and the Internal Revenue Service will not apply income tax to those earnings. However, when that individual withdraws money from the account during retirement, those withdrawals are taxed at their ordinary income tax rate. As of 2018, annual individual contributions to traditional IRAs cannot exceed $5,500 in most cases. If you’re 50 or older, you can contribute up to $6,500 per year using catch-up contributions.

How deductible your traditional IRA contributions are can depend on whether your employer offers a retirement plan. As of 2018, if you’re a single person or file as head of household with a retirement plan available through work and a modified adjusted gross income (MAGI) of $63,000 or less, your IRA contributions are fully deductible. If you earn more than that amount but less than $73,000, only a portion of your contributions may be deductible. If your adjusted gross income is more than $73,000, your IRA contributions are not deductible, unless you do not have a retirement plan available through your employer. The IRS has additional rules for people who use another filing status, such as married filing jointly or married filing separately.

It's also worth noting that, beginning at age 70½, traditional IRA savers are required to start taking minimum distributions (RMDs), based on their account size and life expectancy. Failure to do so may result in a tax penalty equal to 50% of the amount of the required distribution.  

Roth IRAs

Roth IRA contributions are not tax-deductible, but qualified distributions are tax-free. This means that you contribute to a Roth IRA using after-tax dollars, but as the account grows, you do not face any taxes on investment gains. When you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roths also do not have RMDs: If you don't need the money, you don't have to take it out of your account and worry about penalties for failing to do so.

There is, however, a limit as to who can contribute to an IRA. As of 2018, tax filers who are married and file jointly, for example, can contribute up to the annual contribution limit if their combined MAGI is less than $189,000. They can make a reduced contribution if their MAGI is more than $189,000 but less than $199,000. Roth IRA contributions phase out completely when combined MAGI exceeds $199,000. The IRS sets additional income limits for married couples filing separately, single filers and heads of household. 

Simplified Employee Pension IRAs

Self-employed individuals, such as independent contractors, freelancers and small-business owners, can set up SEP IRAs. A SEP IRA adheres to the same taxation rules for withdrawals as a traditional IRA. For 2018, SEP IRA contributions are limited to 25% of compensation or $55,000, whichever is less. 

Business owners who set up a SEP IRA for the company's employees can deduct the contributions from their reported business income and potentially secure a lower tax rate on that income. However, company employees are not allowed to contribute to their accounts, and the IRS taxes their withdrawals as income.

SIMPLE IRAs

The SIMPLE IRA (Savings Inventive Match Plan for Employees) is also intended for small businesses and self-employed individuals. It, too, follows the same taxation rules for withdrawals as a traditional IRA. Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions, too. All the contributions are tax-deductible, potentially pushing the business or employee into a lower tax bracket, which can reduce one's tax bill. The SIMPLE IRA employee contribution limit for 2018 is $12,500, with a $3,000 catch-up contribution allowed for savers age 50 and older. Source: 3

 

IRA Type

Contribution Limit (2018)

Tax-Deductible Contributions?

Tax-Free Distributions?

Subject to Required Minimum Distributions Beginning at Age 70½?

Who Can Establish

Traditional

$5,500; $6,500 if age 50 or older

Yes, but individual deduction amounts are based on income, filing status and retirement plan coverage through your employer

No

Yes

Individual taxpayers and couples*

Roth

$5,500; $6,500 if age 50 or older

No

Yes

No

Individual taxpayers and couples*, subject to MAGI limitations

SEP

The lesser of 25% of compensation or $55,000

Business deductions for employee contributions are limited to the lesser of your total contributions or 25% of employees’ compensation

Self-employed individuals must use a special formula to calculate the amount of contributions they can deduct

No

Yes

Small business owners and self-employed individuals

SIMPLE

$12,500; $15,500 if age 50 or older

All contributions made to employees’ SIMPLE IRAs by the plan owner are tax-deductible

Self-employed individuals can also deduct contributions made to their own SIMPLE IRA

No

Yes

Small business owners and self-employed individuals

*Each spouse can have an individual account. IRAs cannot be jointly held. Couples can set up a spousal IRA for a non-working spouse.

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