IRA

An Individual Retirement Account (IRA) is a type of financial savings account designed to help individuals save for retirement with tax advantages. There are four main types of IRAs, each with its own rules and benefits, primarily focusing on tax deferment or tax-free growth.

An IRA is a versatile and powerful tool for saving for retirement with various tax advantages. Understanding the different types of IRAs and their benefits rules can help individuals make informed decisions to secure their financial future well into retirement.

• Types: Traditional IRA, Roth IRA, SEP IRA, and SIMPLE IRA are included. Depending on an employee's situation, one or a few might be better options. Please see our definitions for each type by following the links or continuing to read below.
• Tax Benefits: Contributions may be tax-deductible or grow tax-free depending on the type of IRA one utilizes.
• Contribution Limits: The Internal Revenue Service (IRS) sets annual limits. For example, in a traditional IRA, the maximum amount a person could contribute in 2023 was $6,500 (provided they were younger than 50 years old). The IRS adjusted this for 2024, raising the maximum amount to $7,000. Once an individual contributes this amount, they will have to leverage other retirement strategies to pay into for the year.
• Distributions: Distributions (or when money is taken out) are usually subject to specific rules and potential penalties if money is taken out too early, depending on the type of IRA.
• Eligibility: Based on income (most common characteristic), employment status, and other factors.
• Flexibility: Offers a variety of investment options for retirement funds, such as stocks, bonds, mutual funds, Exchange-Traded Funds (ETFs), Certificates of Deposit (CDs), and real estate.

Types of IRAs

1. Traditional IRA: Contributions made to a traditional IRA may be tax-deductible. However, how much qualifies will vary based on the contributor's household and income. Taxes are paid on withdrawals during retirement (so they're subject to tax rates in the future rather than the tax rates when the money was contributed). Contributions grow tax-deferred until withdrawn.
2. Roth IRA: Contributions are made with after-tax dollars, but withdrawals during retirement are tax-free (because the taxes were already paid on the front-end contribution). There are no required minimum distributions (RMDs) during the individual's lifetime. RMDs are withdrawals that traditional IRA and 401(k) account contributors must take every year after reaching a certain age. Roth IRAs involve income limits, meaning the amount a person can contribute is correlated directly with their income. Check with the IRS on income limits which can change from year to year.
3. SEP IRA (Simplified Employee Pension): Designed for self-employed individuals (like contractors and freelancers) and small business owners. Contributions are tax-deductible, and investment earnings grow tax-deferred (as taxes will be paid at the back-end when money is withdrawn). If business owners set these up for their employees, employees cannot directly contribute, but the employer does so on their behalf and can write off those contributions.
4. SIMPLE IRA (Savings Incentive Match Plan for Employees): Suitable for small businesses, allowing both employer and employee contributions. Contributions are tax-deductible, and investment earnings grow tax-deferred (like the SEP IRA above).

Tax Benefits of IRAs

• Traditional IRA: Contributions may reduce taxable income in the year they are made, but taxes are due on withdrawals in retirement. For example, if a person contributed $4,000 to their IRA in 2023, their total taxable income for 2023 was reduced by that $4,000, resulting in less taxes paid overall.
• Roth IRA: Contributions do not reduce taxable income in the year they are made, but qualified withdrawals in retirement are tax-free, which might be appealing if future tax rates are unpredictable.
• SEP and SIMPLE IRAs: Contributions reduce taxable income, and earnings grow tax-deferred, like the Traditional IRA.

Contribution Limits

• Traditional and Roth IRAs: The IRS sets annual contribution limits, which can change yearly. For example, in 2023, the limit was $6,500, or $7,500 for those individuals aged 50 or older. In 2024, the limit will be $7,000, or $8,000 for those individuals aged 50 or older.
• SEP IRA: Contributions can be up to 25% of the employee's compensation, with a maximum limit of $66,000 for 2023. In 2024, the maximum limit will rise to $69,000.
• SIMPLE IRA: The employee contribution limit was $15,500 in 2023, with an additional $3,500 catch-up contribution for those aged 50 or older. In 2024, the limit will be $16,000, with the same catch-up contribution for those aged 50 or older.

Withdrawals and Penalties

• Traditional IRA: Withdrawals before age 59 and a half are typically subject to a 10% early withdrawal penalty and income tax. RMDs must start at age 72, meaning that the individual must withdraw a certain amount out of the IRA starting by age 72.
• Roth IRA: Money can be withdrawn anytime without penalty. Earnings can be withdrawn tax-free if the account is at least five years old and the account holder is 59 and six months or older. No RMDs are required during the account holder's lifetime.
• SEP and SIMPLE IRAs: Similar rules to Traditional IRAs, with penalties for early withdrawals and required distributions starting at age 72.

Eligibility Requirements

• Traditional IRA: Anyone with earned income can contribute, but [tax deductibility may be limited based on income and participation in any other employer-sponsored retirement plan (like 401K matching).
• Roth IRA: Income determines eligibility to contribute. For example, in 2023, single filers with a modified adjusted gross income (MAGI) of up to $130,000 could contribute the full amount, but if they made $155,000, they wouldn't be eligible to contribute at all. Tax professionals are helpful in these scenarios, helping maximize advantageous retirement investments and supplementing them with other methods.
• SEP IRA: Available to self-employed individuals and small business owners. Contributions must be made for all eligible employees (eligibility based on age, tenure, and other factors).
• SIMPLE IRA: This option is available to small businesses with 100 or fewer employees. Both employer and employee contributions are allowed, and employee eligibility is based primarily on income.

Flexibility and Investment Options

IRAs offer a wide range of investment options because to grow retirement funds, the money must be actively invested for a return rate. Typically, younger folks invest in opportunities with higher risk and higher rewards and become more conservative as they age and near retirement.

• Stocks: Shares of individual companies.
• Bonds: Debt securities issued by governments or corporations.
• Mutual Funds: Pooled investment vehicles managed by professionals.
• ETFs (Exchange-Traded Funds): These are like mutual funds but traded on stock exchanges (like NASDAQ).
• CDs (Certificates of Deposit): Bank-issued savings certificates with fixed interest rates and maturity dates.
• Real Estate: Certain types of real estate investments are allowed in IRAs.

Providers and employers often offer prearranged bundles of investment packages that might contain a variety of the above options for diversification. It is also recommended to consult a financial advisor for investment and retirement growth.

Advantages of IRAs

• Tax Benefits: Tax deductions on annual contributions or tax-free withdrawals later in life, depending on the type of IRA.
• Long-Term Growth: Potential for significant growth through compounding interest and investment returns. The best compounder of money is time, so starting as early as possible with contributions is advantageous.
• Control: Individuals have control over their investment choices. They are likely to engage in riskier investments early on and de-risk as they age and come closer to retirement, with the potential to withdraw the money.
• Flexibility: IRAs offer various options to suit different financial situations and goals. Individuals may also choose to leverage multiple options at a time.

Common Misconceptions

• Contribution Limits: Some believe they can contribute unlimited amounts, but strict annual limits exist.
• Eligibility: Only some people are eligible for all types of IRAs, especially Roth IRAs with income limits.
• Withdrawal Rules: Misunderstanding the rules can lead to unexpected taxes and monetary penalties.

Statistics

• Popularity: As of 2020, approximately 47.9 million U.S. households contribute to at least one IRA.
• Wealth Building: IRAs held $13.2 trillion in assets in the United States as of mid-2021.
• Growth: The average IRA balance for family households is $333,940.
• Longevity: Roth IRAs have become increasingly popular due to their tax-free withdrawal benefits, especially for younger investors planning for long-term growth.