What is an IRA? Individual Retirement Account explained

An individual retirement account (IRA) is an investment account created specifically for the purpose of saving for retirement. As the name implies, an IRA offers individuals a way to save and invest for retirement with many tax benefits, one of which is tax-free growth on earnings.

Unlike the retirement accounts an employer might offer, such as a 401(k) or 403(b), most types of IRAs are completely managed by you, not your employer. There are some exceptions because certain types of IRAs are also available to small businesses, but most IRAs are completely controlled by the individual.

All IRAs offer tax-free growth so you don’t have to pay taxes on any growth or income earned over time while your money remains in the account. The main difference between the various types of IRAs is how your savings (or contributions) are taxed today and how they are taxed in the future when you take money out.

Here’s what you need to know.

Why invest in an IRA?

An individual retirement account offers an additional avenue to save and invest to achieve financial independence in retirement, and has several benefits:

• Greater retirement savings: All IRAs offer you the ability to save more for your future financial independence or retirement.
• Greater control: Unlike employer-sponsored plans such as a 401(k), IRAs give you full control over where your account is, what investments you choose, and what fees you pay.
• Tax-free growth: Money invested in an IRA will grow tax-free until you take it out.
• Potential tax savings today: Some IRAs allow you to pay no taxes today on the money you contribute and defer those taxes until you start making withdrawals.
• Potential tax savings in the future: Some IRAs let you pay taxes on your contributions today and enjoy potential tax-free withdrawals in the future.

How does an IRA work?

All IRAs have two things in common. First, to contribute to an individual retirement account you must have earned income. For married couples, only one partner must have earned income. Second, all earnings and growth of your investments within the IRA are tax-free while they remain in the account.

Unlike a workplace retirement plan where your employer handles a lot of the set-up, an IRA requires you to take certain steps and make some decisions, including:

• Determining if you are eligible
• Deciding which account to open
• Deciding how much to contribute
• Deciding how you will invest your money
• Naming a beneficiary
• Creating a strategy for using the money

Keep in mind that these decisions may change over time. Retirement planning is an ongoing process that should be reviewed at least once a year, and the amount you contribute and the investments you choose may be different.

What are the different types of IRAs and their advantages and disadvantages?

There are several types of IRAs, but the two most common are traditional IRAs and Roth IRAs.

Traditional IRA

Taxes: No taxes on the money you deposit/contribute. Money grows tax-free. Withdrawals are fully taxable.

Advantages of traditional IRAs

You get an up-front tax break, because your contributions may be eligible to lower your taxable income (called claiming a deduction) today. That will lower your tax bill. If you’re in a high tax bracket, in your highest earning years, or simply want to lower your taxes, a traditional IRA can be a good solution. Your earnings grow tax-free. You have complete control over your retirement choices.

Disadvantages of traditional IRAs

Withdrawals are fully taxable. If your tax bracket is lower when you make withdrawals in retirement this may be less of a factor, but it’s important to keep in mind. If you also have a company-sponsored retirement plan, such as a 401(k), you may not be able to claim a tax break today. You must begin taking distributions from your traditional IRA by age 72 (used to be age 70 ½), whether you need the money or not.

Roth IRA

Taxes: Similar to a traditional IRA, money grows tax-free. The difference is when taxes are paid. With a Roth IRA, contributions are made with money that’s already been taxed, called after-tax contributions. When you pull the money out, assuming you meet all requirements, all earnings are tax free.

Advantages of Roth IRAs

Retirement income is tax-free, as long as the account has been established for five years AND you are over 59 ½. Contributions can be withdrawn any time without taxes or penalties, because you’ve already paid taxes on that money. You do not have to start taking money out at age 72 (or any age). Similar to a traditional IRA, you have full control over where you invest.

Disadvantages of Roth IRAs

There are limits on how much you can contribute based on your income. If you make too much money you may not be able to contribute at all. Instead of a tax break, you pay taxes on the money you invest today.

Other types of IRAs

Rollover IRA

If you start a new job, you can set up a rollover IRA and move your money from your former employer’s plan, such as a 401(k), into it. However, there is a caveat when it comes to creditor protection so it’s important to know if it needs to be part of your strategy.

Spousal IRA

If a married couple only has one working partner, the working partner can establish and fund a spousal IRA for the non-working partner. The non-working partner is the account owner and has full control of the account as well.

Inherited IRA

IRAs allow you to name a beneficiary who will inherit the money following your death. Unless the beneficiary is your spouse, they cannot take over the account and treat it as their own. They must transfer the funds into an inherited IRA that is subject to required distributions every year in most cases.

Small Business IRA

Business owners can also establish IRAs for their businesses and employees, if they have any. Simplified Employee Pension Plans (SEP IRAs) and Savings Incentive Match Plans for Employees (SIMPLE IRAs) give small businesses the opportunity to establish retirement plans without the same level of reporting and oversight that is required for larger plans like 401(k)s.

Who should consider an Individual Retirement Account?

There are four main reasons to consider opening an IRA:

1. You don’t have access to a workplace retirement plan

If your employer doesn’t offer a retirement plan such as a 401(k) or 403(b), an IRA or Roth IRA is the main way to save and invest for retirement with tax advantages.

2. You want to save outside of your retirement plan

Even if you are maxing out your contributions to your retirement plan through work, an IRA or Roth IRA can be a great investment option to supercharge your retirement savings. (You can have both types of plans.)

3. You want to use a backdoor Roth IRA strategy

If your salary is above the income limit for Roth IRA contributions you may be able to take advantage of a backdoor Roth IRA strategy. There are many factors to consider before using this approach so do your homework to make an informed decision.

4. You recently changed jobs

When you change jobs and have money in a retirement plan with your prior employer, you should consider a rollover. Moving money from an old 401(k) to an IRA can give you greater control over your investment decisions and the fees you pay.

Even if an IRA or Roth IRA makes sense for you, there are important contribution limits and eligibility requirements to be aware of to avoid costly penalties.

IRA contribution limits and eligibility

IRA contribution limits

For both traditional and Roth IRAs, in tax year 2023 you can contribute up to $6,500 per year if you are under age 50.

If you are over 50, you can make a catch up contribution of $1,000 for a total of $7,500.

This is an aggregate contribution limit so you can’t put $6,500 into an IRA and $6,500 into a Roth IRA in the same year.

IRA eligibility

To contribute to any type of IRA, you must have earned income for the year (the spousal IRA is an exception).

For traditional IRA contributions, you can always make a contribution, but you may not always be able to claim a tax deduction.

If you or your spouse are not covered by a company-sponsored retirement plan, you can make tax deductible contributions at any income level.

If you are covered by a company-sponsored plan, there are income limits at which you become ineligible for deductible contributions.

Your eligibility to make a Roth IRA contribution relies solely on your income. If your income is over the allowable limit, you can’t contribute.

For individuals, that income limit is $153,000 for 2023. For married couples, the income limit is $228,000. There may be other qualifying considerations to be aware of depending on your tax filing status.

Which type of IRA is right for you?

As a rule of thumb, a traditional IRA makes sense if you believe your tax bracket will be lower in retirement.

A Roth IRA makes sense if you believe your tax bracket is lower today than it will be in retirement.

Predicting future tax rates is nearly impossible, but we can be pretty certain that tax law will change and likely many times. Utilizing different account types that are taxed differently allows you to better adapt to the current and future tax environment and minimize taxes over time while also putting you in control of your retirement income strategy.

Early in your career you may start with contributions to a Roth 401(k) or Roth IRA. As you advance in your career, you may switch to making traditional or before-tax 401(k) contributions and supplementing that with a Roth IRA. You may even want to consider a backdoor Roth IRA strategy if your income makes you ineligible for a regular Roth IRA.

That being said, your strategy needs to be dynamic as your life evolves personally, professionally, and financially, to ensure you maximize your retirement savings and reduce your taxes today, as your money grows, and when you need it in the future.

To learn how a CFP® Professional at Facet can help you determine your eligibility for a traditional or Roth IRA, decide how much to contribute, and integrate these accounts into the financial planning process and your broader strategy, get in touch today.