Individual Retirement Account (IRA)

What Is an Individual Retirement Account (IRA)?

An individual retirement account (IRA) is a savings account with tax advantages that individuals can use to save and invest long-term.

An IRA is similar to a 401(k) account. However, the 401(k) plan is an employee benefit that can be obtained only through an employer.

Any person with earned income can open an IRA retirement savings account in order to save long-term and enjoy the tax benefits they offer.

An IRA can be obtained through a bank, an investment company, an online brokerage, or a personal broker.

Understanding IRAs

Anyone who has earned income can open an IRA. That includes people who have a 401(k) through an employer. The only limitation is on the combined total that they can contribute in a single year through retirement accounts while still getting the tax advantages.

Investors in IRAs can choose from among a wide range of financial products, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds.

There are even self-directed IRAs that permit investors to make all the decisions and give them access to a broader selection of investments, including real estate and commodities. Only the riskiest investments are off-limits.

There are several types of IRAs, including traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. Each has different rules regarding eligibility, taxation, and withdrawals.

Individual taxpayers can establish traditional and Roth IRAs. Small business owners and self-employed individuals can set up SEP and SIMPLE IRAs.

An IRA must be opened with an institution that has received Internal Revenue Service (IRS) approval to offer these accounts. Choices include banks, brokerage companies, federally insured credit unions, and savings and loan associations.

Because IRAs are meant for retirement savings, there is usually an early withdrawal penalty of 10% if you take money out before age 59½. There are some notable exceptions for withdrawals for educational expenses and first-time home purchases, among others.

If your IRA is a traditional account rather than a Roth account, you will owe income tax on an early withdrawal.

What Counts As Income?

You can only contribute to an IRA with earned income that meets the IRA definition. Income from interest and dividends, Social Security benefits, or child support does not count.

Types of Individual Retirement Accounts (IRAs)

The following is a breakdown of the different types of IRAs and the rules regarding each:

Traditional IRA

In most cases, contributions to traditional IRAs are tax-deductible. That is, if you put $6,000 into an IRA, your taxable income for the year decreases by that amount.

However, when the money is withdrawn, it is taxed at your ordinary income tax rate. For 2021, annual individual contributions to traditional IRAs cannot exceed $6,000 in most cases. If you are 50 or older, you can contribute a total of up to $7,000 per year.

For 2021, the IRS changed the income phaseout range for deducting contributions to a traditional IRA for investors with retirement plans at work. The phaseout range for married couples changed from $104,000–$124,000 in 2020 to $105,000–$125,000 and from $65,000–$75,000 to $66,000–$76,000 for singles.

Your income determines whether you can deduct your traditional IRA contributions. Suppose you are a single person or file as head of household and have a retirement plan, such as a 401(k) or 403(b), available at work. Your traditional IRA contributions are fully deductible if your modified adjusted gross income (MAGI) was $65,000 or less in 2020. In 2021, the limit is $66,000. If you're married filing jointly, the limit was $104,000 or less in 2020 and is $105,000 in 2021. If you earn more, you begin to lose deductions.

Use this chart to figure out where you fit.

Deduction Limits If You Have a Retirement Plan at Work

Filing Status

2020 MAGI

2021 MAGI

Deduction

Single or Head of Household

$65,000 or less

$66,000 or less

Full deduction up to your contribution level

More than $65,000 but less than $75,000

More than $66,000 but less than $76,000

Partial deduction

$75,000 or more

$76,000 or more

No deduction

Married Filing Jointly

$104,000 or less

$105,000 or less

Full deduction up to your contribution level

More than $104,000 but less than $124,000

More than $105,000 but less than $125,000

Partial deduction

$124,000 or more

$125,000 or more

No deduction

Married Filing Separately

Less than $10,000

Less than $10,000

Partial deduction

$10,000 or more

$10,000 or more

No deduction

Starting at age 72, holders of traditional IRAs must begin taking required minimum distributions (RMDs), which are based on the account size and the person's life expectancy. Failure to do so may result in a tax penalty equal to 50% of the amount of the required distribution.

In 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act increased the age requirement of taking RMDs from 70½ to 72. It also eliminated the age limit at which a person can contribute to an IRA, which was 70½. A person of any age with earned income can now contribute to an IRA.

Roth IRA

Roth IRA contributions are not tax-deductible, but qualified distributions are tax-free. You contribute to a Roth IRA using after-tax dollars, but you do not have to pay any taxes on investment gains. When you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roth IRAs also do not have RMDs. If you don't need the money, you don't have to take it out of your account. You can still contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.

Roth IRA contribution limits for 2020 and 2021 tax years are the same as for traditional IRAs. However, there is a catch. There are income limitations for contributing to a Roth IRA. The phaseout range for single filers was between $124,000 and $139,000 in 2020 and is between $125,000 and $140,000 in 2021. For married couples filing joint taxes, the phaseout range was $196,000 to $206,000 in 2020 and is $198,000 to $208,000 in 2021.

Income Limits for Contributing to a Roth IRA

Filing Status

2020 MAGI

2021 MAGI

Contributions

Single or Head of Household

Less than $124,000

Less than $125,000

Up to the limit

$124,000 to less than $139,000

$125,000 to less than $140,000

Reduced amount

$139,000 or more

$140,000 or more

Married Filing Jointly or Qualifying Widow(er)

Less than $196,000

Less than $198,000

Up to the limit

$196,000 to less than $206,000

$198,000 to less than $208,000

Reduced amount

$206,000 or more

$208,000 or more

Married Filing Separately

Less than $10,000

Less than $10,000

Reduced amount

$10,000 or more

$10,000 or more

SEP IRA

Self-employed individuals such as independent contractors, freelancers, and small-business owners, can set up SEP IRAs. The acronym SEP stands for simplified employee pension.

A SEP IRA adheres to the same tax rules for withdrawals that a traditional IRA does. For 2021, SEP IRA contributions are limited to 25% of compensation or $58,000, whichever is less.

Business owners who set up SEP IRAs for their employees can deduct the contributions they make on behalf of employees. However, the employees are not allowed to contribute to their accounts, and the IRS taxes their withdrawals as income.

SIMPLE IRA

The SIMPLE IRA is also intended for small businesses and self-employed individuals. The acronym SIMPLE stands for savings incentive match plan for employees. This type of IRA follows the same tax rules for withdrawals as a traditional IRA.

Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions as well. All the contributions are tax-deductible, potentially pushing the business or employee into a lower tax bracket.

The SIMPLE IRA employee contribution limit in 2021 is $13,500, and the catch-up limit (for workers age 50 and older) is $3,000, the same as it was in 2020.

Revenue Ruling 2008-5

In 2008, the IRS issued Revenue Ruling 2008-5, which states that IRA transactions can trigger the wash-sale rule. Should shares be sold in a non-retirement account, followed by substantially identical shares purchased in an IRA within a 30-day period, the investor cannot claim tax losses for the sale. The investment's basis in the individual's IRA won't be increased either.

Comparing IRA Options

Use the chart below to get a better sense of how the different IRAs work.

Note: To view the full chart, use the slider at the bottom to see the column at the far right.

Comparing IRA Types

  IRA Type

  Employee Contribution Limit (2021)

  Tax Deductible Contributions?

  Tax-Free Distributions?

  Subject to Required Minimum Distributions Beginning at Age 72?

  Who Can Establish

  Traditional

  $6,000; $7,000 if age 50 or older

  Yes, but individual deduction amounts are based on income, filing status, and retirement plan coverage through your employer

  Individual taxpayers and couples

$6,000; $7,000 if age 50 or older

  Individual taxpayers and couples, subject to MAGI limitations

  The lesser of 25% of compensation or $58,000

  Business deductions for employee contributions are limited to the lesser of your total contributions or 25% of employees’ compensation   Self-employed individuals must use a special formula to calculate the amount of contributions they can deduct

  Small-business owners and self-employed individuals

  SIMPLE

  $13,500; $16,500 if age 50 or older

  All contributions made to employees’ SIMPLE IRAs by the plan owner are tax deductible   Self-employed individuals can also deduct contributions made to their own SIMPLE IRA

  Small-business owners and self-employed individuals

What Are the Different Types of IRAs?

The most basic is the traditional IRA or the Roth IRA. A traditional IRA gives you an immediate tax benefit: The amount you deposit is deductible from your gross income that year, up to annual limits. You'll owe income taxes on the money only after making a withdrawal. If you have a Roth IRA, you pay income taxes that year on the amount you contribute. You won't owe any taxes down the road when you withdraw the money.

Other types of IRAs are aimed at people in specific circumstances: SEP and SIMPLE IRAs are intended for business owners or self-employed people like contractors and freelancers.

Can I Contribute to Multiple Retirement Accounts in the Same Year?

Yes, but you must be sure that the combined contributions to all your IRAs do not exceed the annual limits set by the IRS.

If you have a 401(k) plan through an employer, you can even contribute to both the 401(k) plan and an IRA. Just stay within the total limit for the year.

Can I Withdraw Money Early From an IRA?

You can if your need is urgent but be prepared for a whopping 10% tax penalty on top of the income taxes due on the balance.

That said, there are allowable withdrawals for certain expenses, like a first-time home purchase or educational expenses.

IRAs are meant to be long-term retirement savings accounts. If you take money out early, you're robbing your own retirement assets.

What Investments Can I Hold in an IRA?

Your choice is vast, with banks, investment companies, and brokerages all vying for your business. Each will offer a selection of IRA accounts, each made up of a mix of investments that may include mutual funds, stocks, exchange-traded funds (ETFs), bonds, and more.

You also have the option of opening a self-directed account that allows you to make all the investment choices. The IRS forbids only the riskiest types of investments like collectibles and precious metals.

What Happens to My IRA When I Die?

All IRA accounts require a named beneficiary. If you die before your IRA assets are exhausted, they will pass to your beneficiary. (For a married couple, the beneficiary is the holder's spouse, unless the spouse agrees in writing that another beneficiary is named.)

If the beneficiary is under retirement age, they will be subject to the same IRA distribution and withdrawal rules.