What an IRA is and How It Works

An IRA is an investment account that provides tax breaks for retirement savings. Investing money in an IRA is one of the best ways to prepare for your later years because anyone with earned income can open one — even those without access to an employer-sponsored retirement plan.

However, before you contribute to an IRA, you should have a sense of which type is right for your situation, and you should learn the rules for both deductible contributions and penalty-free withdrawals.

What is an IRA? IRA stands for individual retirement account. There are several different types, but each one allows you to make tax-advantaged contributions from income you earn to build a nest egg for retirement.

The different kinds of IRAs have different contribution limits, and some also impose income limits on contributors. For example, the two most commonly used IRAs — traditional and Roth — have an aggregate contribution limit of $6,000 in 2021 and 2022, although those 50 or older can make an additional catch-up contribution annually. The catch-up contribution amount is $1,000 for 2021 and 2022, so workers 50 and older could contribute a maximum of $7,000 each year.

IRAs can be opened with any financial institution, including:

Discount online brokers Traditional banks Robo-advisors Investment management firms Once you’ve made a contribution, you can purchase any assets your brokerage allows, including stocks, bonds, and mutual funds.

Types of IRAs

There are several different types of IRAs available, each with their own unique features. Some common types of IRAs include:

Traditional IRAs Traditional IRAs allow individuals to invest pre-tax income for retirement. These contributions grow tax-deferred until withdrawal, and they may also be tax-deductible. While anyone can contribute to a traditional IRA, regardless of income, there are some restrictions.

Contributions are capped at $6,000 in 2021 and 2022, or $7,000 for those who are 50 years of age or older. These limits apply to the total contributions for both traditional and Roth IRAs. Contributions are fully tax-deductible if neither the contributor nor their spouse has a workplace retirement plan. However, the ability to deduct contributions phases out at certain income levels. In 2021, this phase-out occurs at:

• $66,000 for single filers (up to $68,000 in 2022)
• $105,000 for married joint filers with a workplace plan (up to $109,000 in 2022)
• $198,000 for married joint filers whose spouse has a workplace plan (up to $204,000 in 2022)

A traditional IRA can be an ideal choice if an individual expects their tax bracket to be lower during retirement than it currently is. This allows them to claim their tax benefits up front, when they are worth more, and to be taxed on distributions later, when their rate is lower.

Roth IRAs The main difference between a traditional IRA and a Roth IRA is that contributions to a Roth IRA are made with after-tax dollars. While contributions are not tax-deductible in the year they are made, this money grows tax-free, and withdrawals are not taxed during retirement. Like traditional IRAs, Roth IRAs have an aggregate contribution limit of $6,000 in 2021 and 2022, or $7,000 for those 50 years of age or older. However, Roth IRAs have income limits on who can contribute.

If an individual expects their tax rate to increase during retirement, a Roth IRA is a good choice because they can make tax-free withdrawals when their money would otherwise be taxed at a higher rate. Additionally, a Roth IRA can be a good option for those concerned about crossing the income threshold where Social Security benefits become taxable since distributions from a Roth IRA are not counted when determining if Social Security is taxed.

SEP IRAs Simplified Employee Pension IRAs, or SEP IRAs, can be set up by small business owners or self-employed individuals. Only employers and the self-employed can make contributions to this type of account.

The annual contribution limit is the lesser of 25% of employee compensation or $61,000 in 2022 ($58,000 for 2021). There are no income limits for contributing to a SEP IRA, and contributions are deductible in the year they are made.

SEP IRAs are a good choice for self-employed workers or small business owners who want to contribute the maximum amount of money to their retirement account. However, they must contribute the same percentage to all eligible employees’ retirement accounts. For those with a large staff, this could require significant contributions to their employees’ retirement accounts to maximize their own retirement contributions.

Simple IRAs: Employers and self-employed individuals can establish Simple IRA accounts, and both employees and employers can contribute to them. Employees can contribute up to $14,000 in 2022 ($13,500 in 2021), and those 50 and older can make catch-up contributions of up to $3,000 if their plan allows it. There are no income limits for contributions to this type of account.

While Simple IRAs have lower contribution limits, they provide more flexibility in structuring employee contributions.

Rollover IRAs: Rollover IRAs allow you to transfer funds from another retirement account, such as a 401(k) from a former employer, into a new IRA. Although you do not need to open a specific “rollover IRA” to move your funds, doing so may have tax implications. To avoid taxes, transfer your funds into the same type of account that you currently have.

Spousal IRAs: Spousal IRAs are regular IRAs that you can fund on behalf of a non-working spouse. You can use either a traditional or Roth IRA to save for a non-working spouse, with the contribution limit being the same as for traditional and Roth IRAs opened for yourself.

Advantages of IRAs: IRAs have several advantages, including the ability to choose between traditional and Roth IRA accounts, which offer different tax benefits. You can open an IRA without an employer, and they offer a wide variety of investment options, including brokerage accounts, banks, robo-advisors, and self-directed IRAs. Most institutions allow you to open an IRA with no fees or minimum balance, and you can borrow from your account as long as you follow the rules.