An individual retirement account (IRA) is one of the most popular ways people save for retirement. There are several types of IRAs, and each has its own set of benefits. There are important rules regarding how to contribute to and withdraw from IRAs that you should understand before making your contributions. In general, though, it’s often a wise move to periodically put money to work by investing through IRAs.
Along with 401(k)s and taxable brokerage accounts, IRAs are usually an ideal vehicle for building long-term wealth. Knowing all the rules, limits, and even a bit of investing strategy can go a long way toward building your long-term wealth.
What is an IRA?
An individual retirement account (IRA) is a specific set of accounts through which a person with earned income can establish and contribute to with the goal of building a big nest egg. The major upshot of an IRA – both a Roth and a Traditional – is that you can invest in a tax-advantaged way. Unlike a 401(k), anyone with income from a job is able to contribute to an IRA. Small business owners can even establish an IRA for themselves and their employees through various types of IRAs.
For 2022, the annual contribution limit to a Traditional and Roth IRA generally cannot exceed $6,000. If you are age 50 or older, you can make what are known as “catch-up” contributions of up to $1,000 per year, making the limit $7,000 for folks nearing retirement. We find that many investors simply invest periodically through dollar-cost averaging into IRAs – perhaps each month or every quarter.
How an IRA Works
The primary advantage of both Traditional and Roth IRAs is tax savings. A Traditional IRA works by offering account holders a way to maximize their long-term investment growth potential through a current-year tax break. A Roth IRA, on the other hand, uses after-tax dollars as contributions, which makes tax-free growth and withdrawals possible.
It’s important to know that withdrawals from IRAs can get hit with a 10% early distribution tax penalty. Selecting the account type that’s right for you comes down to your personal financial situation.
What’s great about an IRA is that the world of investment choices is at your fingertips. By contrast, investing within a 401(k) usually means you are limited to just a set of mutual funds, which sometimes carry high fees. That’s not the case with IRA investing. You can buy low-cost index exchange-traded funds (ETFs), mutual funds, stocks, bonds, and so many other types of investments. Efficient diversification is made easier with IRAs.
Another big benefit of contributing to your IRA regards tax savings. Contributions to a Traditional IRA are eligible for a tax deduction in the current year, then the investments within the IRA grow tax-deferred until you withdraw from the account. Tax-advantaged growth through IRA investing is a significant way folks can hit their retirement goals faster.
With a Roth IRA, the major advantage is seen at withdrawal since qualifying distributions are tax-free in retirement since contributions were made with after-tax dollars. So, it’s essentially the reverse of a Traditional IRA in that sense.
IRAs are a fantastic option for people who do not have access to an employer-sponsored retirement plan through their job. While the contribution limit is much lower than, say, a 401(k) account, you can still benefit from saving periodically into an IRA. Moreover, if you contribute to a 401(k) or 403(b) plan through your job, you can also open and fund an IRA. Finally, a non-income earning spouse can invest for their retirement with what’s known as a spousal IRA.
Different Types of IRAs
There are several types of IRAs available. The two most common are the Traditional and Roth. Let’s go through both flavors so you get a sense of which might make more sense for you.
Traditional IRA: Contributions to a Traditional IRA are eligible to be tax-deductible, but your annual adjusted gross income (AGI) must be below certain limits, which we’ll talk about later. To get an idea of the tax savings, let’s say you earn $65,000 per year and are in the 22% tax bracket. By contributing $5,000 to a Traditional IRA, your taxes owed in the current year drop by $1,100. Withdrawals in retirement count toward your taxable income in the year they are made, so timing your distribution strategy with the help of online resources or a financial advisor can help.
Roth IRA: Contributions to a Roth IRA are made with post-tax dollars, so there is no upfront tax benefit, but money and investments housed in a Roth IRA grow tax-free and can be tax-free upon withdrawal in retirement.
There are also small business IRAs out there.
Simplified Employee Pension (SEP) IRA: A SEP IRA is commonly set up by a small business owner to help their employees save and invest for retirement. Self-employed people might also have SEP IRAs. Making SEPs attractive is a higher annual contribution limit compared to a Traditional or Roth IRA, but they work very similarly to a Traditional IRA as pre-tax dollars are used to fund the account, and distributions are taxed as ordinary income. The 2022 annual contribution limit to a SEP IRA is the lesser of $61,000 or 25% of compensation.
Savings Incentive Match Plans for Employees (SIMPLE) IRA: A SIMPLE IRA is another retirement plan established by small businesses. This account type allows employees to make retirement contributions while the employer is required to contribute. A SEP, by contrast, does not allow employee contributions. The 2022 annual contribution limit to a SIMPLE IRA is $14,000 with a $3,000 catch-up amount.
What Are the IRA Contribution Rules?
The rules around Traditional and Roth IRA contributions can get tricky. The most important rule is arguably the annual contribution limit which we outlined earlier. You must also be aware of certain income thresholds.
For 2022, the IRS set the phaseout range for Traditional IRA contributions’ tax deductibility at $68,000 to $78,000 of Modified Adjusted Gross Income (MAGI) for single tax filers. Those who are Married Filing Jointly must have a MAGI under $78,000 to take full advantage of IRA contributions’ tax-deductibility feature. Those figures assume you have a retirement plan through your employer. If you are married to someone with a workplace retirement plan, but you are not, your phaseout range is much higher at $204,00 to $214,000. You generally have until tax day the following year to make annual contributions.
As you can see, IRA contribution rules are not quite as straightforward as how much you can put into your 401(k) each year. There are a few variables you must be aware of before you make IRA contributions. The good news is that if you make a mistake when putting money into either a Traditional or Roth IRA, you can reverse it through an IRA recharacterization or simply by removing excess contributions in a timely manner. Working with a financial planner or tax professional could be prudent to avoid owing excessive fees and penalties.
Don't be intimidated, though. Online tools and calculators can help you determine what contribution amount you are eligible for, and even which IRA type is best for your situation and goals.
How Should I Choose Investments for My IRA?
Once you’ve figured out which IRA type is right for you and you know how much you can contribute, opening and funding the IRA is straightforward. You can select from a variety of low-cost online brokerage platforms since almost all of them now offer no-fee IRAs.
On those sites, and using Allio’s online resources, you can research what ETFs, mutual funds, or stocks might be right for you. When choosing your investments, you should first determine your time horizon and goals with your money. For example, are you funding a near-term purchase like saving for a wedding or a down payment on a house? If so, then an IRA might not be the best choice since early withdrawals can face a 10% penalty. Though a Roth IRA can be useful for those situations since Roth IRA contributions can be withdrawn tax-free and penalty-free.
More commonly, however, IRAs are used to build retirement savings. That’s usually a long-term goal, so choosing aggressive investment options like a stock ETF or even a set of individual stocks makes sense for young people. Researching what asset allocation works best for you is also a wise strategy before jumping into an investment.
Are There Rules About Withdrawals I Should Know?
Yes, there are several key rules to be mindful of before you pull money out of your IRA. First, withdrawing from a Traditional IRA before age 59 ½ means you will owe not only income tax on the distribution but also a 10% early withdrawal penalty. State tax might apply, too.
If possible, other means to generate cash should be considered before taking an early Traditional IRA withdrawal. The good news is that there are several exceptions to the 10% penalty including withdrawals for a first-time home purchase (up to $10,000), paying for educational expenses, distributions due to death or disability, if you have excessive medical costs, along with a few other less common scenarios.
Most individuals simply wait until age 59 ½ to begin pulling money out of their IRAs. So-called “normal distributions” from a Traditional IRA are added to your income and taxed at ordinary income tax rates. Roth IRA withdrawals after age 59 ½ do not face income tax on either contributions or earnings.
Mandatory Traditional (and Rollover) IRA withdrawals must begin on April 1 of the year after you hit age 72. Required Minimum Distributions are taken each year thereafter. It’s critical that retirees understand RMD rules since missing just one year’s RMD gets slapped with a whopping 50% tax on the amount that was not distributed. Many brokerage sites today calculate your yearly RMD for you, but if you have multiple IRAs, it might be more complicated.
Common IRA Scenarios
Knowing your situation with respect to your income, whether you have a retirement plan on the job, what accounts and income your spouse has, and your overall goals and objectives all factor into IRA scenarios. You might be unsure and even confused by all the rules. Let’s cut through the clutter with some real-world examples.
The Young Saver. Let’s say you are in the early innings of your career and want to invest for retirement. With a time horizon potentially decades long, investing aggressively in a stock-heavy portfolio might make sense. Also, it’s likely your income is low today compared to what you hope it will be, say, 20 years down the road. So you decide to take advantage of your low marginal tax bracket now, and contribute the annual $6,000 max into a Roth IRA at a no-fee online broker. You then purchase a single index ETF and call it a day. You can even establish monthly contributions to automate the process going forward.
A Growing Family & Income. Now we’ll assume you are married, earn a solid income, contribute to your 401(k), but still want to ensure you and your spouse are on the right track toward retirement. Unfortunately, your $120,000 per year income makes you ineligible for taking advantage of a Traditional IRA’s tax deduction benefit. But there’s another strategy you can employ. You as the higher-earning spouse can contribute to a Roth IRA while your non-income earning spouse can contribute to a spousal IRA.
The Backdoor Roth IRA. Here’s a bonus scenario that applies to people with a high income: the Backdoor Roth IRA. This strategy involves making contributions to a Non-Deductible IRA, then immediately performing a Roth Conversion. The logic goes that since the individual has a high income, they are not eligible for either a Traditional IRA’s tax deduction or even a Roth IRA altogether. A legal way to bypass the Roth income limit is to make Backdoor Roth contributions. There are rules regarding this strategy, so make sure all your ducks are in a row before going about it.
The Bottom Line
IRAs are popular vehicles to save and invest for retirement. There are important contribution and withdrawal rules to know before putting money to work in them. What’s great about Traditional and Roth IRAs is that you can invest for your future in a tax-savvy way with minimal fees. Individuals, married couples, and even small business employees can make IRA contributions.