An individual retirement, a.k.a IRA, is an account that allows you to save money for retirement in a tax-advantaged manner. With an IRA, you to save either pre-tax money or before-tax money toward retirement. You can open an IRA from a bank, a credit union, or an online broker and investment company. IRAs have many investment options, including stocks, bonds, mutual funds, index funds, and ETFs.
Popular IRAs include the Roth IRA and traditional IRA. The main difference between both IRAs is when tax benefits are realized. With A Roth IRA, you don’t get upfront tax benefits, but you grow your account tax-free and withdraw your funds tax-free. For the traditional IRA, on the other hand, your contributions can be tax-deductible, allowing you to defer tax until retirement.
This article will explain the basics of IRAs and why having one is important even if you have retirement benefits from your work, such as 401(k) plans.
How does an IRA work?
An IRA is a retirement savings account that comes with tax benefits. You can open IRAs from a brokerage company or bank. Depending on the account you open, you can contribute before-tax or after-tax money. For example, if you open a Roth IRA, your contributions will come from after-tax wages. On the other hand, if you choose a traditional IRA, your contributions might be tax-deductible depending on your income and tax filing status.
IRAs come with contribution limits each year. For 2024, the IRA contribution limits are $7,000. If you are 50 or older, you will have an extra $1,000 catch-up contribution.
If you have a Roth IRA, you will grow your account tax-free and pay no income tax on qualified withdrawals during retirement. Additionally, the Roth IRA does not require RMDs, and you can pass on the account to your heirs tax-free.
If you have a traditional IRA, you will grow your account on a tax-deferred basis and pay tax during retirement. Traditional IRAs also come with required minimum distributions(RMDs), which are withdrawals you must take from the account when you reach a certain age.
An IRA can help you transfer money from one retirement account to another. For example, you can use a Rollover IRA to transfer your money from an old 401(K) account into an IRA without paying tax or an early withdrawal penalty.
Types of Individual Retirement Accounts (IRAs)
There are three types of individual retirement accounts:
- Roth IRA
- Traditional IRA, and
- Rollover IRA
What is a Roth IRA?
A Roth IRA is a retirement account where you make contributions with after-tax money. According to the IRS, this allows you to grow your account tax-free and pay no income tax on qualified distributions during retirement. In addition, a Roth IRA does not come with the required minimum distributions(RMD) when you turn 73.
This account is good for people who wish to pay taxes upfront and never have to worry about taxes during retirement. Another benefit of this account is that the money can be transferred to your descendants tax-free. As Investopedia denoted, however, your descendants must take out RMDs.
Everyone is not eligible to contribute to a Roth IRA. According to Charles Schwab, the Internal Revenue Service (IRS) has income limits determining your eligibility to contribute to a Roth IRA. You cannot contribute to a Roth IRA when your income exceeds these limits. The maximum you can contribute to a Roth IRA in 2024 is $7,000. If you are 50 or older, you will get an extra $1,000 in catch-up contributions.
Related post: How to open a Roth IRA: Create a Roth IRA in 6 steps
What is a traditional IRA?
A traditional IRA allows you to make before-tax contributions, but all your contributions might not be tax-deductible. According to the Internal Revenue Service (IRS), your traditional IRA contributions will be tax-deductible based on your income, filing status, and other benefits you or your spouse (when filing jointly) have from work.
The traditional IRA behaves more like a pre-tax 401(k) as deductible contributions come with income tax during retirement, and it requires RMDs when you turn 73. The only difference is that your contributions will be much lower on a traditional IRA, and no employer’s match on this account.
A traditional IRA is good for you if you don’t have other retirement benefits such as 401(K) from your workplace.
The traditional IRA will give you access to various investment options such as ETFs, Mutual Funds, Index Funds, individual stocks, etc. In addition, you can shop around for lower fees on your account.
Related post: 401(K) Vs. Traditional IRA: Which retirement plan is better?
What is a Rollover IRA
Rollover accounts move money from employer-sponsored accounts such as 401(K) into your IRAs. You need a Rollover IRA to avoid taxes when moving money from one retirement account to another.
According to Schwab, with a rollover,
- You will preserve the tax-deferred status of your retirement savings
- Pay no income taxes, or
- Early withdrawal penalties when you transfer your money.
If you do not use a rollover IRA, the transaction could be treated as an early withdrawal, which would trigger a premature withdrawal penalty and tax on the money you took out.
IRA contribution limits in 2024
The maximum contribution limit to an IRA is $7,000 or $8,000 if you are 50 or older. For 2023, you can contribute up to $6,500 and an extra $1,000 catch-up contribution if you are 50 or older. These contribution limits are the same for the Roth IRA and traditional IRA. According to the IRS, your contribution cannot exceed your income. If your taxable income is less than the contribution limits allowed by the Internal Revenue Service (IRS) on IRAs, your maximum contribution will be your taxable income.
Not everyone can contribute to a Roth IRA. Your modified adjusted gross income(MAGI) directly affects your Roth IRA contributions. Read the IRS guidelines for more details on Roth IRA eligibility and MAGI levels.
Even if you can contribute up to $7,000 to your traditional IRA, the deductible amount will depend on your income, other tax-benefited accounts from work, and filing status.
Early withdrawal penalty on IRAs
You must pay a 10% penalty when you make a premature withdrawal from your IRAs. You might also pay tax on the deductible contributions you made on your traditional IRA. This 10% penalty can be waived if you meet the IRS exceptions.
Are contributions to my IRA tax-deductible?
The money you contribute to your traditional IRA can be tax-deductible. The deductible amount will depend on your income, filing status, and other benefits you or your spouse has from work, such as 401(k) plans. For the Roth IRA, your contributions are not tax-deductible. In order words, every dollar you contribute to a Roth IRA comes from after-tax wages.
Is having an individual retirement account (IRA) a good idea?
Yes. Having an IRA is a good idea due to the direct or indirect tax benefits you get. The following are reasons you should open an IRA.
- You can take advantage of the tax benefits that come with these IRAs
- IRAs will give you access to investment options you would not have with employer-sponsored accounts such as 401(K) and 403(b).
- Since employer-sponsored accounts have higher fees, opening an IRA can help you lower management fees.
- IRAs can help you lower your retirement taxes. Instead of putting everything in 401(K), where you pay tax on all your distributions, you can contribute to a Roth IRA. The contributions to your Roth IRA will be tax-free during retirement.
Is 401k the same as an individual retirement account?
No. Although they are both types of retirement accounts, a 401(k) and an Individual Retirement Account (IRA) are not the same. A 401k is an employer’s retirement plan where employees can contribute a portion of their pre-tax or after-tax wages to this account. The employer may match these contributions up to a certain amount.
On the other hand, an IRA is an account that an individual opens independently of their employers. Like a 401k, contributions to an IRA may be tax-deductible, depending on the individual’s income and other factors. However, there are different types of IRAs, such as a traditional IRA and a Roth IRA, each with different rules about contributions and tax benefits.
