Individual Retirement Account (IRA)

What Is an Individual Retirement Account (IRA)?

An individual retirement account (IRA) is a savings account with tax advantages that individuals can open to save and invest in the long term.

Like a 401(k) account that an employee obtains as a benefit from their employer, an IRA is designed to encourage people to save for retirement. Anyone who has earned income can open an IRA and enjoy the tax benefits these accounts offer.

You can open an IRA through a bank, an investment company, an online brokerage, or a personal broker.

Key Takeaways

  • IRAs are retirement savings accounts with tax advantages.
  • Types of IRAs include traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.
  • Money held in an IRA usually can't be withdrawn before age 59½ without incurring a hefty tax penalty of 10% of the amount withdrawn.
  • There are annual income limitations for deducting contributions to traditional IRAs and for contributing to Roth IRAs.
  • IRAs are meant to be long-term retirement savings accounts. If you take money out early, you defeat that purpose by diminishing your retirement assets.

Understanding IRAs

Anyone with earned income can open and contribute to an IRA, including those who have a 401(k) account through an employer. The only limitation is on the combined total that you can contribute to your retirement accounts in a single year while still getting the tax advantages.

When you open an IRA, you can choose to invest in a wide range of financial products, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds. There are even self-directed IRAs (SDIRAs) that permit investors to make all the decisions and give them access to a broader selection of investments, including real estate and commodities. Only the riskiest investments are off-limits.

There are several kinds of IRAs, including traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. Each has different rules regarding eligibility, taxation, and withdrawals. Individual taxpayers can establish traditional and Roth IRAs, and small business owners and self-employed individuals can set up SEP and SIMPLE IRAs. An IRA must be opened with an institution that has received Internal Revenue Service (IRS) approval to offer these accounts. Choices include banks, brokerage companies, federally insured credit unions, and savings and loan associations.

Because IRAs are meant for retirement savings, there is usually an early withdrawal penalty of 10% if you take money out before age 59½. There are some notable exceptions—withdrawals for educational expenses, for example, and for first-time home purchases, among others. If your IRA is a traditional account rather than a Roth account, you will owe income tax on an early withdrawal.

What Counts as Income?

You can only contribute to an IRA with earned income that meets the IRA definition. Income from interest and dividends, Social Security benefits, or child support does not count.

What Are the Different Types of IRAs and Their Rules?

Following is a breakdown of the different types of IRAs and the rules regarding each one.

Traditional IRA

In most cases, contributions to traditional IRAs are tax-deductible. So if you put $4,000 into an IRA, your taxable income for the year decreases by that amount. Then, when you withdraw the money in retirement, it is taxed at your ordinary-income tax rate. In that way, your money grows on a tax-deferred basis in a traditional IRA.

For 2021 and 2022, the annual individual contributions to traditional IRAs cannot exceed $6,000 in most cases. If you are 50 or older, you can contribute up to $7,000 per year (the extra $1,000 is considered a catch-up contribution).

If you don't have a retirement plan at work, your traditional IRA contributions are fully deductible. But if you (or your spouse, if you are married) have a retirement plan at work, such as a 401(k) or 403(b), your modified adjusted gross income (MAGI) determines whether and how much of your traditional IRA contributions can be deducted. In 2021, if you are single or file as head of household and have a retirement plan at work, your traditional IRA contributions are fully deductible if your MAGI is below $66,000. If you are married filing jointly, your MAGI must be less than $105,000. From there, you begin to lose deductions as your MAGI increases.

It is possible to have both a Roth and a traditional IRA, or several IRAs at different institutions. However, the total contribution to all of your IRAs cannot exceed $6,000 each year (or $7,000 for those older than 50).

For 2022, the IRS changed the income phaseout range for deducting contributions to a traditional IRA for investors with retirement plans at work. The phaseout range for married couples increased from $105,000 to $125,000 in 2021 to $109,000 to $129,000, and for single taxpayers or heads of households from $66,000 to $76,000 in 2021) to $68,000 to $78,000.

If you contribute to an IRA and are married to someone covered by a workplace plan, but you are not, the phaseout range in 2022 goes up to $204,000 to $214,000 from $198,000 to $208,000 in 2021.

Use this chart to figure out where you fit.

Deduction Limits If You Have a Retirement Plan at Work
Filing Status 2021 MAGI 2022 MAGI Deduction
Single or Head of Household      
  $66,000 or less $68,000 or less Full deduction up to your contribution level
  More than $66,000 but less than $76,000 More than $68,000 but less than $78,000 Partial deduction
  $76,000 or more $78,000 or more No deduction
Married Filing Jointly      
  $105,000 or less $109,000 or less Full deduction up to your contribution level
  More than $105,000 but less than $129,000 More than $109,000 but less than $129,000 Partial deduction
  $125,000 or more $129,000 or more No deduction
Married Filing Separately      
  Less than $10,000 Less than $10,000 Partial deduction
  $10,000 or more $10,000 or more No deduction

Roth IRA

Roth IRA contributions are not tax-deductible, but qualified distributions are tax-free. You contribute to a Roth IRA using after-tax dollars, but you do not have to pay any taxes on investment gains. When you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roth IRAs also do not have required minimum distributions (RMDs). If you don't need the money, you don't have to take it out of your account. You can still contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.

Roth IRA contribution limits for 2020 and 2021 tax years are the same as they are for traditional IRAs. However, there is a catch. There are income limitations for contributing to a Roth IRA. The phaseout range for single filers is between $125,000 and $140,000 in 2021 and $129,000 and $144,000 in 2022. For married couples filing joint taxes, the phase-out range is $198,000 to $208,000 in 2021, and $204,000 to $214,000 in 2022.

Income Limits for Contributing to a Roth IRA
Filing Status 2021 MAGI 2022 MAGI Contributions
Single or Head of Household      
  Less than $125,000 Less than $129,000 Up to the limit
  $125,000 to less than $140,000 $129,000 to less than $144,000 Reduced amount
  $140,000 or more $144,000 or more Zero
Married Filing Jointly or Qualifying Widow(er)      
  Less than $198,000 Less than $204,000 Up to the limit
  $198,000 to less than $208,000 $204,000 to less than $214,000 Reduced amount
  $208,000 or more $214,000 or more Zero
Married Filing Separately      
  Less than $10,000 Less than $10,000 Reduced amount
  $10,000 or more $10,000 or more Zero

SEP IRA

Self-employed individuals such as independent contractors, freelancers, and small-business owners, can set up SEP IRAs. The acronym SEP stands for simplified employee pension.

A SEP IRA adheres to the same tax rules for withdrawals that a traditional IRA does. For 2022, SEP IRA contributions are limited to 25% of compensation or $61,000, whichever is less.

Business owners who set up SEP IRAs for their employees can deduct their contributions on behalf of employees. However, the employees cannot contribute to their accounts, and the IRS taxes their withdrawals as income.

SIMPLE IRA

The SIMPLE IRA is also intended for small businesses and self-employed individuals. The acronym SIMPLE stands for savings incentive match plan for employees. This type of IRA follows the same tax 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 as well. All the contributions are tax-deductible, potentially pushing the business or employee into a lower tax bracket.

The SIMPLE IRA employee contribution limit in 2022 is $14,000, up from $13,500 in 2021, and the catch-up limit (for workers aged 50 and older) is $3,000 for 2022, the same as it was in 2021.

Wash-Sale Rule and IRAs

In 2008, the IRS issued Revenue Ruling 2008-5, which states that IRA transactions can trigger the wash-sale rule. Should shares be sold in a non-retirement account, followed by the purchase of substantially identical shares in an IRA within a 30-day period, the investor cannot claim tax losses for the sale. The investment's basis in the individual's IRA won't increase either.

Required Minimum Distributions

Starting at age 72, holders of traditional IRAs must begin taking RMDs, which are based on account size and the person's life expectancy. Failure to do so may result in a tax penalty equal to 50% of the amount of the required distribution.

In 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act increased the age requirement for taking RMDs from 70½ to 72. It also eliminated the age limit at which a person can contribute to an IRA, which was 70½. A person of any age with earned income can now contribute to an IRA.

Comparing IRA Options

Use the chart below to get a better sense of how the different IRAs work.

Note: To view the full chart, use the slider at the bottom to see the column at the far right.

Comparing IRA Types
  IRA Type   Employee ​Contribution Limit (2022)   Tax-Deductible Contributions?   Tax-Free Distributions?   Subject to Required Minimum Distributions Beginning at Age 72?   Who Can Establish
  Traditional   $6,000; $7,000 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 $6,000; $7,000 if age 50 or older   No   Yes   Not in the account holder's lifetime (heirs of Roth accounts are subject to RMDs)   Individual taxpayers and couples, subject to MAGI limitations
  SEP   The lesser of 25% of compensation or $61,000   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   $14,000; $17,000 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

What Are the Advantages of an IRA?

An individual retirement account, or IRA, provides a tax-advantaged way to save for retirement. Depending on what type of IRA you use, an IRA can either reduce your current tax bill now or at the time of retirement. Any investment gains are usually tax-free. Also, IRAs are insured by the Federal Deposit Insurance Corporation (FDIC), a government-run agency that provides protection when a financial institution fails. The FDIC covers customer deposits—up to $250,000 per account in most cases—that are held at FDIC-insured banks or savings and loan associations.

How Can I Start a Roth IRA or Traditional IRA?

You can create your individual retirement account, or IRA, at most banks, credit unions, or financial services providers. Fidelity, Charles Schwab, and E*Trade are all examples of brokers that provide IRA accounts. Opening an account is as easy as visiting their branch or website, and providing your bank and tax information.

When Can I Withdraw From an IRA?

The best time to withdraw from an IRA is after age 60. If you withdraw before age 59½, you will incur a 10% early withdrawal penalty, in addition to taxes on the withdrawal. There are some exceptions to this penalty for medical expenses, disabilities, or other unusual life events. Generally speaking, the longer you can wait before taking distributions, the more time that money has to grow.

How Is a 401(k) Plan Different from an Individual Retirement Account (IRA)?

Both 401(k) plans and IRAs provide tax advantages to employees investing for their retirement. The main difference is who provides them. A 401(k) is usually provided by an employer, with contributions automatically deducted from the employee's paycheck. Some companies will also match their employee's contributions. 401(k) plans have higher contribution limits, but an IRA can be set up by anyone, regardless of their employer. However, most 401(k) plans offer a limited range of mutual funds and ETFs to choose from, while a typical IRA offers a wider range of funds, stocks, and other securities.

Article Sources

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