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R etirement is the most expensive financial goal that most people save for. Many workers have access to a 401(k) plan through their job — and maybe even an employer match — which can go a long way in helping someone reach their retirement goals. 

But a 401(k) isn’t right for everyone. First, not everyone has access to a 401(k) plan. And even those that do may max out their plan and need another tax-advantaged option, or they may simply prefer the flexibility and ownership of an account outside their employer.

That’s where an IRA comes in. This popular type of retirement account offers plenty of tax advantages and helps you make even more progress toward your financial goals. Keep reading to learn more about how IRAs work, the different types of IRAs, the rules for these accounts, and much more.

What is an IRA?

An IRA — short of individual retirement account — is a tax-advantaged account designed to help workers save for retirement. An IRA is a great option for anyone with earned income, regardless of whether you have access to an employer-sponsored retirement plan. 

For workers without a 401(k) or another plan through their work, an IRA can be their primary method of saving for retirement. And for those with a workplace retirement plan, an IRA can serve as a supplement.

How IRAs Work?

An IRA is similar to any other type of brokerage account you might open. First, you can generally open this type of account with any major broker, and the good news is, you can open one in a matter of minutes.

Because IRAs are self-managed, you can choose from any investment option you want rather than being limited like you might be with a workplace retirement plan. You’ll have access to stocks, bonds, mutual funds, ETFs, and other assets. You can opt to build your own portfolio, or even invest in a target-date fund that serves as your entire portfolio and adapts with you as you age.

Types of IRAs

When you decide to open an IRA, you’ll have two primary types to choose from. While they’re similar in several ways, they offer some different tax benefits that may be best suited for different individuals. Below you can learn more about the traditional and Roth IRA to get a better idea of which might be best for your situation.

1. Traditional IRA

A traditional IRA allows workers to make tax-deferred contributions for retirement. The funds you contribute to your traditional IRA are pre-tax. You can take a deduction for your contributions on your tax return, which reduces your taxable income (and, therefore, the amount of taxes you’ll owe that year).

It’s important to note that depending on your income and whether you have an employer-sponsored retirement account, you may not actually be able to deduct your traditional IRA contributions. Anyone without a workplace retirement plan can deduct their full contribution, but those who are covered by a retirement plan at work (or whose spouses are covered one), will face the limitations in the table below:

Filing StatusModified AGIDeduction Allowed
Single or head of household$68,000 or lessFull deduction
Single or head of household$68,000 – $78,000Partial deduction
Single or head of household$78,000 or moreNo deduction
Married filing jointly$109,000 or lessFull deduction
Married filing jointly$109,000 – $129,000Partial deduction
Married filing jointly$129,000 or moreNo deduction
Married filing separatelyLess than $10,000Partial deduction
Married filing separately$10,000 or moreNo deduction

While the funds are in the traditional IRA, they will continue to grow tax-deferred. You won’t be on the hook for the capital gains or income taxes that you might be subject to on investment earnings in a taxable brokerage account. Finally, when you begin to withdraw funds during retirement, you’ll pay income taxes on it.

2. Roth IRA

A Roth IRA is another tax-advantaged account to help you save for retirement. While there are some similarities between a traditional and Roth IRA, the major difference is the tax advantages. When you contribute to a Roth IRA, you do so after tax. The money you contribute has already been taxed on your paycheck, and there’s no deduction for your contributions.

The good news is once the funds are in your Roth IRA, you’ll never pay taxes on them again. Like with a traditional IRA, the money in your retirement account grows tax-free without capital gains or income taxes. And when you withdraw the funds during retirement, you’ll do so completely tax-free.

IRA Rules

If the traditional and Roth IRAs sound like excellent tools to help you save for retirement, it’s because they are. But if you’re considering opening this type of account, it’s important to understand a few rules you’ll be subject to.

Contribution Limits

The IRS only allows you to contribute up to $6,000 per year to either a traditional or Roth IRA. If you’re age 50 or older, you can have an additional catch-up contribution of $1,000 for a total of $7,000.

One important rule for IRA limits is that you can’t contribute more than your taxable compensation for the year. So if you earned $6,000 or more, then you’re free to contribute up to the $6,000 contribution limit. But if your income for the year was only $4,000, then that would be the most you could contribute.

The one exception to this rule is if your spouse has earned income. Often referred to as a spousal IRA, stay-at-home parents and other non-working spouses can use their spouse’s taxable compensation to be eligible to contribute to an IRA. Both spouses can contribute up to $6,000 separately. However, the combined contributions can’t exceed the spouse’s total taxable compensation.

Eligibility

Anyone can contribute to a traditional IRA, though as we mentioned, not everyone can deduct their contributions. However, the eligibility rules for a Roth IRA are a bit more strict. To contribute to this type of account, you must have income under a certain limit. The table below shows the different contribution rules for various filing statuses and income levels.

Filing StatusModified AGIContribution Allowed
Single or head of householdLess than $129,000The full amount
Single or head of household$129,000 – $144,000A reduced amount
Single or head of household$144,000 or moreNone
Married filing jointlyLess than $204,000The full amount
Married filing jointly$204,000 – $214,000A reduced amount
Married filing jointly$214,000 or moreNone
Married filing separatelyLess than $10,000A reduced amount
Married filing separately$10,000 or moreNone 

If you aren’t technically eligible to contribute to a Roth IRA, there is still a way to take advantage of these powerful tax benefits. You can use a backdoor Roth IRA to convert your traditional IRA funds to a Roth IRA. There’s no income limit on this type of transaction, but if you’ve already taken a tax deduction of your traditional IRA contributions, then you’ll have to pay income taxes on the amount you convert.

Withdrawal Rules

IRAs are intended to help you save for retirement. As a result, the IRS generally doesn’t allow you to withdraw from your account before age 59½. Any funds withdrawn earlier will be subject to a 10% early withdrawal penalty in addition to the taxes owed.

However, there are a few exceptions where the IRS does allow you to withdraw money early. First, when you contribute to a Roth IRA, you’ve already paid income taxes on your contributions. As a result, you can withdraw those at any time without taxes or penalties. However, any investment earnings you withdraw early will be subject to fees.

There are also several other exceptions that apply to both traditional and Roth IRAs:

  • Up to $10,000 to buy or build your first home
  • Qualified higher education expenses
  • Qualified birth or adoption expenses
  • Medical expenses that are more than 7.5% of your AGI
  • Medical premiums during a period of unemployment
  • Disability or death

Required Minimum Distributions

Traditional IRAs are subject to what is known as a required minimum distribution (RMD). Once you reach age 70½, you’re required to start taking minimum distributions from your account. You can withdraw more than the required amount, but you can’t withdraw less. If you don’t meet the RMD requirement, you could be subject to a 50% excise tax on the amount you didn’t withdraw but should have.

RMDs apply only to traditional IRAs, but not to Roth IRAs. In the case of a Roth IRA, you’ve already paid income taxes on your contributions and won’t pay taxes on that money again. As a result, the IRS has no incentive to require that you take distributions before you want to.

Traditional vs. Roth IRA: Which is Right For You?

One of the biggest questions that people have about IRAs is whether a traditional or Roth IRA is better. There’s not necessarily one type of account that’s better than the other. Instead, it comes down to which is better for your situation.

In general, pre-tax contributions, like those of a traditional IRA, are better if you expect your tax rate during retirement to be lower than your current tax rate. After-tax contributions, like those of a Roth IRA, are better if you expect your tax rate during retirement to be lower than your current tax rate.

But because of the other rules associated with IRAs, there’s a bit more nuance to it, especially for high-income earners. If you have a high income and are covered by a workplace retirement plan, then you aren’t allowed to deduct your traditional IRA contributions. Because of that, it seems that a Roth IRA would make more sense. However, high-income earners also can’t contribute to a Roth IRA.

Luckily, you still have a couple of options. First, if you have a high income and believe the pre-tax retirement contributions are better for your situation, then you can focus on maxing out your workplace retirement plan before resorting to an IRA. And if you do contribute to an IRA, because you can’t deduct your contributions anyway, it makes sense to take advantage of the Roth conversion to take advantage of that tax benefit instead.

IRA vs. 401(k)

For many workers, the 401(k) plan is their first foray into investing for retirement (or investing at all). You might be wondering just how an IRA differs from a 401(k) and which is better.

Before we talk about the differences between a 401(k) and an IRA, we should first talk about their very important similarity: their tax advantages. Just like an IRA, a 401(k) offers tax-free growth on your investments. You can also choose between traditional or Roth contributions to take advantage of the tax benefit that works best for you.

Now that we’ve talked about that important similarity, let’s talk about a few key differences between the 401(k) and the IRA.

One major difference between a 401(k) and an IRA is how they’re offered. 401(k) plans are typically offered by for-profit companies for their employees. An IRA, on the other hand, is an individual account that anyone can set up for themselves.

Another major difference between a 401(k) and an IRA is the contribution limit. Remember how the IRS only allows you to contribute up to $6,000 to an IRA? Well in the case of a 401(k), you can contribute up to $20,500 per year, and individuals age 50 or older can have a catch-up contribution of an additional $6,500. Additionally, your employer can make contributions to your account for a combined total with your contributions of up to $61,000.

The final important difference between a 401(k) and an IRA is the investment options. As we mentioned, an IRA is unlimited in your investment options. You can choose from any investment offered by the brokerage firm you choose. But with a 401(k) plan, your employer puts together a menu of investment options that’s usually relatively small. And you can only choose from the investments on that list.

As far as choosing between a 401(k) and an IRA, it depends on a variety of factors. If your employer offers a matching contribution, be sure to contribute at least enough to take advantage of the entire match. But after that, you can choose to continue contributing to your 401(k) plan, contribute to an IRA instead, or do a combination of both.

IRAs for Self-Employed People

The two IRA options we discussed above are available to anyone, but there are also a couple of options specifically designed for self-employed individuals. Of course, you can use a traditional or Roth IRA if you’re self-employed. But the options we’ll discuss in this section combine some of the benefits of an employer-sponsored retirement plan with those of an IRA.

SEP IRA

A Simplified Employee Pension (SEP) IRA is designed for self-employed individuals, especially freelancers and contractors. With this type of account, you can set aside up to $61,000 or 25% of your income, whichever is less. If you have employees in your business, you can also contribute to accounts for them as well.

SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is another type of retirement account for self-employed individuals. If you choose this plan and have employees, you are required to contribute to their accounts as well. Employees can contribute up to $14,000 to a SIMPLE IRA, and the company can contribute up to 3% of compensation.

How to Open an IRA

You can easily open an IRA through any major brokerage firm. Most popular brokers offer both traditional and Roth IRAs, meaning you can choose the one that works best for you. In general, there are two places you should consider for housing your IRA:

  • Brokerage firm: Major brokerage firms like Vanguard, Fidelity, and Schwab make it easy to open your own IRA. When you choose one of these platforms, you can choose your own investments for your retirement portfolio.
  • Robo-advisor: A robo-advisor is technically a type of brokerage firm, but instead of one where you choose your own investments, the robo-advisor does it for you. You answer a few questions based on your investment goals and risk tolerance and the platform chooses your investments on your behalf.

When it comes to choosing the right platform, you should first consider whether a traditional brokerage firm or robo-advisor works best for your needs. After that, you can compare individual platforms by comparing the investments available, fees, user interface, and other factors that are important to you.

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"You must gain control over your money or the lack of it will forever control you."

Dave Ramsey

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