Individual Retirement Account (IRA)

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Individual Retirement Account (IRA)

What is an IRA?

An Individual Retirement Account (IRA), formally an Individual Retirement Arrangement, is a tax-advantaged account that helps individuals save for retirement. IRAs are available to people with earned income and can be opened at banks, brokerages, credit unions, and other IRS-approved institutions. They are intended for long-term retirement saving, and withdrawals before retirement age are generally subject to taxes and penalties.

How IRAs work

  • Contributions are made with earned income only (wages, salary, self-employment). Investment income, Social Security, and similar receipts do not qualify as earned income.
  • IRAs let you invest in stocks, bonds, mutual funds, ETFs and, in self-directed IRAs, a broader set of assets such as real estate and certain private investments.
  • Annual contribution limits apply across all IRAs you own (traditional + Roth combined), with higher catch-up limits for those age 50 and older. Check the IRS for current limits.
  • Withdrawals are typically taxable and subject to a 10% early withdrawal penalty if taken before age 59½, unless an exception applies (e.g., disability, certain medical expenses, first-time home purchase, higher education, etc.).

Main types of IRAs

Traditional IRA

  • Contributions may be tax-deductible depending on your income and whether you (or a spouse) are covered by a workplace retirement plan.
  • Earnings grow tax-deferred; withdrawals in retirement are taxed as ordinary income.
  • Required Minimum Distributions (RMDs) apply (see RMD section).

Roth IRA

  • Contributions are made with after-tax dollars (no tax deduction up front).
  • Qualified withdrawals, including earnings, are tax-free.
  • No RMDs during the original owner’s lifetime.
  • Eligibility to contribute phases out above certain income thresholds.

SEP IRA (Simplified Employee Pension)

  • Designed for self-employed individuals and small-business owners.
  • Employer makes contributions on behalf of employees; employees do not contribute.
  • Contributions are subject to percentage-of-compensation limits set by the IRS.
  • Withdrawals follow traditional IRA tax rules.

SIMPLE IRA (Savings Incentive Match Plan for Employees)

  • Intended for small businesses.
  • Employees may contribute; employers must make contributions (matching or nonelective).
  • Contribution limits differ from SEP and traditional IRAs and include catch-up contributions for older participants.
  • Withdrawals follow traditional IRA tax rules.

Required Minimum Distributions (RMDs)

  • RMDs apply to traditional IRAs (and employer plans like 401(k)s); Roth IRAs do not require RMDs during the owner’s lifetime.
  • RMD start age has changed under recent law: the required beginning age is 73 for those reaching the threshold after certain law changes, with a planned further increase to age 75 in later years. The withdrawal amount is based on account balance and life expectancy tables.
  • Missing an RMD can trigger a severe tax penalty (a large percentage of the amount that should have been withdrawn), though the penalty may be reduced if corrected promptly. Check current IRS guidance for exact rates and calculation methods.

Other important rules and considerations

  • Combined contribution limit: The IRS sets a total annual contribution limit that applies across all traditional and Roth IRAs you own.
  • Deductibility of traditional IRA contributions depends on household income and workplace retirement coverage; phase-outs apply.
  • Wash-sale interaction: Selling a security at a loss in a taxable account and buying a substantially identical security in an IRA within 30 days can disallow the loss for tax purposes and will not adjust basis in the IRA (IRS Rev. Rul. 2008-5).
  • Self-directed IRAs allow alternative investments but carry higher complexity, liquidity issues, and fraud risk—exercise caution and perform due diligence.
  • FDIC insurance: Cash deposits held in IRA accounts at FDIC-insured banks are protected up to standard limits per depositor, per institution, under FDIC rules. Investment holdings (stocks, funds) are not FDIC-insured.

Opening and managing an IRA

  • You can open an IRA at most financial institutions (banks, brokers, credit unions). Compare investment options, fees, and services.
  • Choose the account type that aligns with your tax situation: traditional IRAs offer potential upfront tax savings; Roth IRAs provide tax-free retirement distributions.
  • Keep track of contribution limits, income phase-outs, and RMD obligations. Revisit your choice if your employment status or income changes.

IRA vs. 401(k) — key differences

  • Sponsorship: 401(k) plans are employer-sponsored; IRAs are individually established.
  • Contribution limits: 401(k)s generally have higher contribution limits than IRAs.
  • Employer match: Employer contributions are common in 401(k)s; IRAs typically have no employer match.
  • Investment choices: IRAs often offer a wider selection of investments than many workplace plans.

Key takeaways

  • IRAs provide tax-advantaged retirement saving through traditional, Roth, SEP, and SIMPLE structures.
  • Eligibility, tax treatment, and withdrawal rules vary by IRA type; contribution and deduction limits depend on income and workplace coverage.
  • Withdrawals before age 59½ usually trigger a 10% penalty plus taxes unless an exception applies.
  • Traditional IRAs have RMDs; Roth IRAs do not during the original owner’s lifetime.
  • Check current IRS rules for up-to-date contribution limits, income phase-outs, RMD ages, and penalties before making decisions.