IRAs can be a useful part of a retirement savings strategy, but the rules vary depending on the type of account you choose. Understanding how IRAs work—including who can contribute, how much you can contribute, and how withdrawals are taxed—can help you decide how they may fit into your broader retirement plan.
What is an IRA?
An IRA, or individual retirement account, is a tax-advantaged account that can help you save and invest for retirement. Depending on the type of IRA, you may receive a tax benefit either when you contribute or when you withdraw funds. Most IRAs offer a wide selection of investment options, such as individual stocks, bonds, mutual funds, exchange-traded funds (ETFs), and certificates of deposit (CDs).
How does an IRA work?
Unlike an employer-sponsored retirement plan, such as a 401(k), an IRA is generally opened by an individual through a brokerage firm, bank, or other financial institution. Once the account is open, you can contribute money, choose how to invest it, and potentially benefit from tax advantages based on the type of IRA you choose. Your contributions, investment choices, taxes, and withdrawals are all subject to IRS rules.
Traditional vs. Roth IRA
There are two main types of IRAs to consider: traditional IRAs and Roth IRAs. The main difference is when you receive the potential tax benefit.
Traditional IRA
Traditional IRAs are generally funded with pre-tax dollars. If contributions qualify, they can offer a tax deduction now, while withdrawals are generally subject to ordinary income tax in retirement. Deductibility can depend on your income and whether you or your spouse is covered by an employer-sponsored retirement plan, such as a 401(k). Traditional IRAs are subject to required minimum distributions (RMDs), and early withdrawals may trigger a 10% U.S. federal tax penalty.
Roth IRA
Roth IRAs are funded with after-tax dollars, so you don’t receive an immediate tax deduction. However, qualified withdrawals (generally those made after age 59½ and after a five-year holding period) are tax-free, and contributions can generally be withdrawn at any time tax- and penalty-free. Roth IRAs are not subject to RMDs for the original owner, but you must meet IRS income limits to contribute.
How to choose between a traditional IRA and a Roth IRA
A general guideline is to consider when you expect your tax rate to be higher. If you think your tax rate on withdrawals in retirement may be higher than your marginal tax rate today, a Roth IRA may be worth considering because qualified withdrawals in retirement may be tax-free. If you think your tax rate today may be higher than in retirement, a traditional IRA may be more appealing because it may allow you to receive a tax deduction now and pay taxes on withdrawals later.
If you expect your tax rate to be about the same, the income tax difference may be less significant. In that case, your decision may come down to other factors, such as whether you want a potential tax break now, tax-free qualified withdrawals later, or more tax flexibility in retirement. And remember, you can split your contributions between accounts, for example, 50% contributed to a Roth and 50% to a traditional IRA. The combined contribution just can’t be over the annual contribution limit.
Other types of IRAs
In addition to traditional and Roth IRAs, there are other types of IRAs designed for specific situations, such as rolling over assets from a workplace retirement plan, saving as a self-employed individual or small-business owner, inheriting retirement assets, or contributing on behalf of a minor or spouse without earned income.
- A rollover IRA allows you to move retirement funds from an old employer-sponsored retirement plan into an IRA. “Rolling over” your savings in this way may allow you to preserve the tax-deferred status of your retirement assets, thus avoiding taxes or early withdrawal penalties at the time of transfer.
- A SIMPLE IRA, or Savings Incentive Match Plan for Employees, is a retirement savings plan for self-employed individuals and small businesses with 100 or fewer employees. Employers can make contributions for employees, and employees can also contribute.
- A SEP-IRA, or Simplified Employee Pension IRA, is another way for self-employed individuals and business owners to set up a retirement savings plan for themselves and their employees. These accounts are funded by the employer, and contribution limits are generally higher than traditional or Roth IRA limits.
- An inherited IRA (also known as a beneficiary IRA) is opened when someone inherits a retirement account after the death of the original owner.
- A custodial IRA is a traditional IRA or Roth IRA opened by a parent, grandparent, or other custodian for a minor who has earned income for the year. The minor assumes ownership of the account when they reach the age of adulthood determined by state law.
- A spousal IRA allows a working spouse to fund a traditional IRA or Roth IRA for a spouse who does not have earned income. To qualify, the couple must file a joint tax return. Source