An Individual Retirement Account also known as IRA is an investment account specifically designed for retirement savings. Traditional IRAs and Roth IRAs are opened by individuals, while SEP IRAs and SIMPLE IRAs are for self-employed and business owners. IRAs offer tax benefits that reward you for saving which make them very attractive for anyone interested in saving for the future. Generally, you (or your spouse if married) must have earned income to contribute to an IRA - it is a requirement.
With an IRA, you can invest in stocks, commodities, bonds and other assets or asset classes. You can open an IRA account at a bank or a broker. With a broker, you’ll be able to invest in stocks and bonds, while banks generally offer Certificates of Deposit and savings accounts. For a long term goal like retirement, we recommend stocks and bonds because of their higher returns. (See how to invest your IRA by cliking HERE.)
The traditional IRA and the Roth IRA are two of the most popular type of accounts, they allow you to save $6,000 per year ($7,000 if you’re above the age of 50), even if you’re also contributing to a 401(k) or other workplace savings plan. Those annual IRA contribution limits are the same for both 2020 and 2019, and they're up from $5,500 and $6,500 in 2018.
How do IRAs work
- With a traditional IRA, contributions can reduce your tax bill in the year you contribute (if you qualify for that tax break), and you won’t owe income taxes until you withdraw the money in retirement. With a Roth IRA, contributions are not tax-deductible, but your investments grow tax-free and you can withdraw money tax-free in retirement.
- There are other types of IRAs. For example, the backdoor Roth IRA is a strategy for opening a Roth IRA even if you exceed the income limits. Self-directed IRAs offer alternative investments for do-it-yourself investors. SEP IRAs and SIMPLE IRAs are for self-employed people and business owners. See below for more details about these and other IRAs.
- The IRA withdrawal rules do let you withdraw your money any time from an IRA, but you may face a 10% penalty and a tax bill if you take out your money before age 59.5, unless you qualify for an exception. Read on for more details on withdrawal rules.
There are four main types of IRAs: Traditional, Roth, SEP and SIMPLE.
With a traditional IRA, generally you can deduct the amount of your contributions on your tax return. Every year you make a contribution, your taxable income is reduced by the amount of your contribution — that means a smaller tax bill. Your money then grows tax-deferred. You won’t owe income taxes until you withdraw the money from your account. Anyone — regardless of income — can contribute to a traditional IRA. But the amount of your contribution that you’re allowed to deduct from your taxes may be limited by your income if you or your spouse has access to a retirement plan at work. If you (and your spouse) don't have a retirement plan at work, generally you can take a full deduction for your traditional IRA contribution, up to your maximum contribution level. Note: The income limits apply to your modified adjusted gross income (MAGI), which is your adjusted gross income with some deductions and exclusions added back in. See IRS Publication 590-A, Worksheet 1-1, for complete instructions on figuring MAGI for traditional IRAs. See the Traditional Roth contribution limits for 2019 and 2020 HERE. If you’re eager to get an upfront tax break today, a traditional IRA may be a good choice. Or, if you expect to pay a lower tax rate in retirement, then delaying the tax bill until then makes sense.
If you’ve got the willpower to wait to get your tax break, the Roth can be an especially attractive option. With a Roth, contributions are not tax-deductible, but your money grows tax-free — you never owe taxes on the investment gains in your account — and you can withdraw money tax-free in retirement. While you can’t deduct Roth contributions from your taxable income while you’re saving, in retirement your Roth withdrawals are not taxed at all. That goes for contributions and investment earnings. (With a traditional IRA, you pay taxes on both your contributions and earnings when you withdraw money.) The Roth comes with another big perk: You can take out money you contributed to a Roth IRA at any time without penalty. But there are rules about early withdrawals of investment earnings and other transferred funds — see Roth IRA withdrawals for details. There are income limits that prevent higher earners from contributing to Roths. (However, in that situation, a backdoor Roth IRA is another option — more on that below.) See the Roth contribution limits for 2019 and 2020 HERE. Note: The income limits apply to your modified adjusted gross income (MAGI), which is your adjusted gross income with some deductions and exclusions added back in. See IRS Publication 590-A, Worksheet 2-1, for complete instructions on figuring MAGI for Roth IRAs.
SEP stands for “simplified employee pension.” These accounts are a useful retirement savings tool for small-business owners and self-employed people. Like a traditional IRA, a SEP IRA offers a tax deduction on contributions. Your savings grow tax-deferred, and withdrawals in retirement are taxed at regular income tax rates. If you have eligible employees, the IRS requires you to contribute to their accounts at the same rate that you contribute to your account. For example, if you’re saving 10% of your compensation, then you must contribute the same percentage of employees’ compensation to their accounts. Employees generally can’t contribute to a SEP IRA (though some SEP IRAs allow for traditional IRA contributions). The big appeal of these accounts for business owners is that the maximum annual contribution is $57,000 in 2020 (up from $56,000 in 2019), much higher than the $6,000 max for traditional IRAs. One caveat: You can’t contribute more than 25% of compensation. Read more about SEP IRAs.
SIMPLE IRAs are retirement savings accounts for small companies, generally with 100 or fewer employees. Compared with a 401(k), a SIMPLE IRA is relatively easy for employers to set up. (SIMPLE stands for Savings Incentive Match Plan for Employees.) Employers are required to contribute to the plan, based on specific IRS rules. And, unlike a SEP IRA, with a SIMPLE IRA employees can contribute their own money, up to $13,500 in 2020 (up from $13,000 in 2019), plus an extra $3,000 catch-up contribution for people 50 and older. The amount employees contribute will reduce their taxable income for the year, and their money will grow tax-deferred until they withdraw it in retirement, at which point income taxes apply on withdrawals. Read more about SIMPLE IRAs.
Other IRA Types
Backdoor Roth IRA
If your income priced you out of making Roth IRA contributions, fear not. You can still open a Roth, thanks to the backdoor Roth IRA option. (The name “backdoor Roth” is not an official account name; it describes a tax strategy.) Put simply, you open a traditional IRA and then convert it to a Roth. Ideally, your traditional IRA accounts — the one you want to convert plus other traditional IRAs you might have — consist entirely of nondeductible contributions. If not, be prepared for a tax bill. The IRS’s pro-rata rule means that if you have traditional IRA contributions for which you’ve taken a tax deduction, even if those contributions are in another traditional IRA account, some portion of the money you convert to the Roth IRA likely will be taxable. Read more about backdoor Roth IRAs.
Generally, to contribute to an IRA, you need to have earned income. A spousal IRA is one exception to that rule: these accounts let spouses who don’t work for pay contribute to either a traditional IRA or a Roth IRA, based on their working spouse’s income. The spousal IRA is owned by the non-working spouse, and the maximum contribution is $6,000 ($7,000 if 50 or older). But there’s another limit: the total contributions of both spouses to each of their IRAs can’t exceed the working spouse’s earned income. Read more about spousal IRAs.
Technically, almost all IRAs are self-directed, in that you choose your own investments for the account. But “self-directed” has come to describe a special type of IRA: one that lets you invest in alternative investments, such as real estate or a privately-held company. You’ll need to find a custodian who’s willing to let you do that — the brokers that are household names generally don’t offer self-directed IRAs. Self-directed IRAs can come in the traditional or Roth flavor, and they have the same income and eligibility rules. The only difference is the type of investments you own in the account. Read more about self-directed IRAs.
An inherited IRA, also known as a beneficiary IRA, comes with some very specific rules — and you want to follow them so you avoid a big tax bill. Keep in mind that the rules vary depending on your relationship with the deceased person. Read more about inherited IRAs.
Opening Your IRA Account
Before choosing a provider, ask yourself how involved you want to be in the management of your investments:
- If you want to choose investments for yourself, an online brokerage is a good way to go. Speak to our agents to learn more.
- If you want help managing your retirement account, consider a robo-advisor — a service that selects low-cost and risk-appropriate investments for you. Speak to our agents to learn more.
Did you find this article helpful