What is An Individual Retirement Account (IRA) and How Does It Work?

What is an IRA?

An individual retirement account (IRA) is an excellent way to save for your future. It is a tax-deferred investment account, meaning that you can defer taxes on the money you put into it until you withdraw it at retirement. Depending on which type of IRA you choose, your contributions may be eligible for a tax deduction now or withdrawals may be exempt from taxes in the future. The Internal Revenue Service (IRS) labels these accounts as “individual retirement arrangements.”

How does an IRA work?

An Individual Retirement Account is a type of retirement savings account offered by brokerage firms and banks. It allows you to save and invest for your future. You can use pre-tax or post-tax dollars to make contributions to an IRA. These funds can be invested in stocks, bonds, exchange-traded funds (ETFs), and other types of assets. The growth in your account balance depends on how you invest, as well as the amount of contribution you make to the IRA.

There are five main types of IRAs: traditional, Roth, SEP (Simplified Employee Pension), SIMPLE (Savings Incentive Match Plan for Employees), and Rollover. Typically, only those people who have earned income are allowed to open and contribute to an IRA. Additionally, there is a maximum amount of contributions you can make each year depending on the type of account.

When it comes time for withdrawals, you may face a 10% penalty along with tax bills if you withdraw money before age 59 1/2, unless you meet certain exceptions. This is why it’s important to be aware of the rules and regulations governing your chosen IRA. With proper planning and investment, an IRA can help you build a strong financial future.

Benefits of an IRA

The main advantage of investing in an IRA is the potential for tax savings. Contributions to traditional IRAs are typically made with pre-tax dollars. It means that you can deduct them from your income when filing taxes and potentially pay fewer taxes overall.

• Contributions to a traditional IRA may be eligible for a tax deduction in the year they are made, with taxes due when distributions are taken during retirement.
• Contributions to a Roth IRA do not offer an immediate tax deduction or benefit, but withdrawals in retirement will be tax-free.

An IRA can also provide access to a greater range of investment options than what is available through your workplace retirement plan. This means that you can potentially diversify your retirement portfolio and invest in assets that may not be otherwise accessible or cost-effective through your employer-sponsored plan. Additionally, even if you are already maxing out contributions to a 401(k) or pension, an IRA can be a great way to supplement your retirement savings. Also, it ensures that you have enough income to last throughout your retirement. Ultimately, the tax benefits of an IRA combined with its added investment options make it a smart choice for anyone looking to maximize their retirement savings.

Five types of IRAs

Here is a look at five common types of IRAs and their features:

1. Traditional IRA

Contributions to traditional IRAs are an attractive way for taxpayers to reduce their taxable income. Through a contribution of $3,000, individuals can deduct this amount from their taxable income when filing taxes. This means up to $3,000 in potential savings on the taxes owed each year. However, it is important to note that withdrawals taken during retirement are counted as ordinary income and therefore subject to taxation.

Married individuals who have a retirement plan through their employer or their spouse’s employer may be limited in the amount they can deduct from their taxable income when contributing to an IRA due to contribution limits. The amount that can be deducted will decrease as the taxpayer’s income increases. Those who do not have a retirement plan at work will be able to deduct the full amount of their IRA contribution, regardless of their income level.

2. Roth IRA

Roth IRAs are a great retirement savings option for those who have a long time before they retire. Certified Financial Planner Matt Aaron, founder of Washington, D.C.-based Lux Wealth Planning, an affiliate of Northwestern Mutual, explains why: Contributions to Roth IRAs are not tax-deductible, but withdrawals from them are tax-free and there are no taxes on investment gains. As Aaron put it, “The question is, do you want to pay your taxes now or later? For me, I’d rather pay taxes now.”

In addition to potentially minimizing taxes paid on withdrawals in the future, Roth IRAs can help combat inflation since money loses value over time. Aaron compares this to paying taxes on the seed rather than the harvest. He cautions, though, that no one has a magic ball and can never predict what will happen in the future. However, preparing for potential tax increases now by contributing to a Roth IRA could be a smart option.

3. SEP IRA

Generally, SEP IRAs are retirement accounts for self-employed people or small-business owners with few or no employees. Like traditional IRAs, contributions to a SEP IRA are tax-deductible. It means that these savings can reduce the amount of taxes you owe in the year you make them. Your investments then grow tax-deferred until you reach retirement age, at which point distributions are taxed as income.

In 2023, contributions to SEP IRAs are limited to 25% of an individual’s compensation or $66,000, whichever is less. Unfortunately, there isn’t a catch-up contribution option for individuals over the age of 50 with SEP IRAs. Additionally, if business owner contributes to a SEP IRA for themselves, then they are also obligated to make proportional contributions for each eligible employee.

4. SIMPLE IRA

SIMPLE IRAs (Savings Incentive Match Plans for Employees’ Individual Retirement Accounts) are a great way for small businesses with fewer than 100 employees to provide employees with retirement savings. Contributions to SIMPLE IRAs are tax-deductible, just like traditional IRAs, and the investments grow tax-deferred until retirement. In 2023, employee contribution limits for a SIMPLE IRA are $15,000 per year for those under age 50 and an additional $3,500 catch-up contribution is available to those aged 50 and older. It’s important to note that employer contributions are mandatory with a SIMPLE IRA.

5. Rollover IRA

Rollover IRAs are a great way to keep your retirement savings organized and streamlined in the event of a job change. By transferring assets from employer-sponsored plans such as 401(k)s into an IRA account, you can have more control over where and how your investments are managed. This is especially helpful if you wish to avoid managing multiple accounts at once. With a rollover IRA, you can move eligible assets quickly and securely without the need to cash out any of your investments. This helps ensure that you will continue to benefit from tax-advantaged retirement savings while maintaining the freedom to choose where and how your money is invested.

IRA contribution limits in 2023

In 2023, both Traditional and Roth IRAs will have a maximum contribution limit of $6,500 with an additional catch-up contribution of up to $1,000 if you are 50 or older. It’s important to note that the combined contribution limits apply to both IRA types. So, if you choose to open both traditional and Roth IRAs, the total amount you can contribute collectively must not exceed the overall limit of $7,500.

Traditional IRA deduction limits

When considering a traditional IRA as an option to take advantage of the tax benefits, it is essential to be aware of the income limits that affect deducting contributions. Generally, if you (or your spouse) have a retirement plan at work, there will be an upper limit on how much of your traditional IRA contribution can be deducted from your taxes. The amount deductible is based on your Modified Adjusted Gross Income (MAGI) for the year.

Generally, it is possible to take distributions from a traditional IRA starting at age 59 1/2. If you do so before then, you may be subject to a 10% penalty (with certain exceptions). This penalty is in place to discourage early withdrawals from retirement accounts. You are also required to start taking minimum distributions when you reach a specific age. Beginning in 2023, this age is 73.

Roth IRA contribution limits

Contributions to a Roth IRA have income limits which cause the amount you can contribute to be phased out and eventually eliminated completely once a certain level of income is reached.

If you earn too much to contribute to a Roth IRA, you can try the backdoor Roth method instead.

How to open an IRA

Brokers and robo-advisors are the two popular ways to get an IRA.

Brokers

If you prefer to manage your retirement investments yourself, an online broker is the perfect solution. To make it easy for you we have reviewed a range of IRA accounts, so you can quickly compare and choose the one that suits you best.

Robo-advisors

For a hassle-free approach to selecting investments for your retirement account, look no further than a robo-advisor. These use algorithms to design portfolios with low costs and suitable risk levels tailored specifically to you. We have compiled a list of the best robo-advisors, allowing you to quickly find the one that will meet your requirements.