IRAs (Individual Retirement Accounts) – a Comprehensive Guide

An infographic that explains what an IRA is, the different types, and what their advantages and disadvantages are.

Planning for the future is no easy task. It’s hard to predict what life will hold for you, especially decades into the future. It might feel foolish to be thinking about retirement as you start your first real job, but in reality, it is never too early to start saving for retirement

Actually, the earlier you start saving, the better because of compounding interest and returns. You do not just earn interest on your principal, but you also earn interest on previous interest earned! When you start saving early, your money has many decades to grow and might enable you to have the retirement of your dreams.

Tax-advantaged retirement accounts are helpful tools to encourage saving for retirement. Besides employer-sponsored 401(k) type retirement plans, there are different types of tax-advantaged Individual Retirement Accounts or IRAs.

In this guide, we explain in detail what IRAs are, how they work, different types, contributions, withdrawals, how to invest in them, and their benefits and disadvantages so that you can make an informed decision if IRAs are a good addition to your portfolio.

What Is an IRA and How Do They Work?

Individual retirement accounts are designed to let you save money for your retirement in a tax-friendly and advantageous way. IRAs are accounts set up with IRS-approved financial institutions to support easy, tax-friendly retirement savings. 

There are different types of individual retirement accounts, and each one comes with different benefits and tax advantages. However, their general premise is that you contribute to your IRA every month through automatic paycheck deduction. Once in the account, your contributions and/or gains can accumulate tax-free until you withdraw your money at retirement. IRAs offer a much wider variety of investment options than are typically offered inside employer-sponsored retirement plans such as 401(k)s. 

As a contributor, you can select where you want to invest your money. The investment options are almost limitless and include cash in savings accounts and certificate of deposits (CDs), individual stocks, bonds, mutual funds, exchange-traded funds (ETFs), and even real estate.

An IRA can only be opened with financial institutions that have received IRS approval to offer these types of retirement accounts, such as banks, brokerages, federally insured credit unions, and savings and loan associations.

There are 2 types of IRAs for individual taxpayers, traditional IRAs and Roth IRAs. There are also 2 types for small-business owners and self-employed individuals, SEP IRAs and SIMPLE IRAs. 

Many larger employers offer 401(k) type employer-sponsored tax-advantaged retirement accounts. The main advantage of this type of account is that besides employee contributions, the employer often matches part of the employee contribution up to a certain percentage. This matching contribution is essentially “free money,” and your savings rate is supplemented by whatever percentage your employer has decided to contribute. Another advantage is that contribution limits for 401 (k)s are a lot higher than for IRAs.

One of the main drawbacks of a 401(k) plan is that they usually only offer limited investment options. 

Types of IRA Accounts

There are different types of individual retirement accounts. The types of individual retirement accounts you can select from may depend on your income, tax situation, the risk you want to take, and whether you and your spouse already contribute to an employer-sponsored retirement plan. Here are some of the most popular types of IRA accounts.

Traditional IRA

Traditional IRAs are some of the most common retirement accounts. With a traditional IRA, you make contributions to your IRA as often as you want to. In most cases, contributions are tax-deductible. This means that if you contribute $3,000 to your traditional IRA, your taxable income decreases by that same amount. These contributions are called pre-tax contributions. 

However, when you withdraw your money during retirement, your withdrawals will be taxed at your ordinary income tax rate at the time of retirement. This is often an advantage as most people are in a lower tax bracket during retirement. Therefore, they will pay fewer taxes and can keep more of their savings.

Besides the advantage of reducing your taxable income, any interest or earnings you gain on your savings and investments are often tax-deferred until retirement, meaning you do not have to pay tax on them until you withdraw your money during retirement. Instead, you can reinvest any earnings and take advantage of compounding in the account.

IRAs have contribution limits. The 2021 limit for traditional IRA contributions and Roth IRA contributions is $6,000, with an optional catch-up contribution of another $1,000 for anyone age 50 or older, making the total allowable contribution $7,000 per year.

Individuals who don’t have a 401(k) type retirement account through their employer can contribute to a tax-deductible traditional IRA regardless of how much they earn. 

However, for employees who contribute to an employer-sponsored retirement account, there are income limits for IRA tax-deduction eligibility. The tax deduction is phased out for individuals whose Modified Adjusted Gross Income (MAGI) is between $66,000 and $76,000 and couples filling jointly making between $105,000 and $125,000. If they make more than that, there is no tax deduction for IRA contributions.

If only one spouse contributes to a 401(k) plan, the IRA tax deduction is phased out if the couple’s income is between $198,000 and $208,000 in 2021.

Many retired people depend on individual retirement accounts for a steady flow of income during retirement. However, IRA withdrawals should carefully be planned as they are regulated and can be subject to taxes, penalties, and other fees depending on the type of IRA you have and when you want to start making withdrawals.

There is a penalty for early withdrawal from any IRA.  If you make withdrawals from a traditional IRA before age 59½, a 10% penalty tax will be triggered in most situations, whether you withdraw contributions or earnings. This means that you have to pay a 10% penalty of your withdrawal to the government plus the income tax you owe on the withdrawal amount. Additional potential state-tax penalties might apply as well. The IRS has approved certain situations in which you can make withdrawals without having to pay that penalty. Certain exceptions are available and will count as qualified distributions, but the 10% penalty is universal for the most part. 

Examples of some penalty-free, early-withdrawal exceptions are certain unreimbursed medical expenses, permanent disability, higher education expenses, and when you inherit an IRA. Remember, you will be liable for any income taxes due at the time of withdrawal.

Once you reach age 72, you are required to take Required Minimum Distributions (RMD). This means you are required to take annual minimum distributions from your traditional IRA. The IRS will tell you what your minimum withdrawal will be. It will depend on the balance of your account and your life expectancy factor. If you do not withdraw the amount required, you may be subject to a 50% penalty tax.

An infographic that explains the differences between a traditional IRA and a Roth IRA.

Roth IRA

Contributions to a Roth IRA are after-tax contributions, and contributions are therefore not tax-deductible. You can withdraw contributions you made to your Roth IRA anytime, tax- and penalty-free. However, you may have to pay taxes and penalties on earnings in your Roth IRA. 

One advantage of a Roth IRA is that your interest or earnings accumulate tax-free, meaning you can earn interest on your earnings and take advantage of compounding. Any earnings you withdraw are considered qualified distributions if you’re 59½ or older, and the account is at least five years old, making them tax- and penalty-free.

If you are 59½ or over and do not meet the 5-year rule, distributions of earnings count as income, and you will have to pay federal income taxes on them, but not the 10% early withdrawal penalty. However, if you withdraw Roth IRA earnings before age 59½, besides having to pay income taxes, the 10% penalty will usually apply as well. The penalty can be waived if you qualify for an IRS exception, such as permanent disability, or the withdrawal is used to purchase a first home ($10,000 limit).

The 2021 contribution limit for a Roth IRA is $6,000, with an optional catch-up contribution of another $1,000 for those over 50.

In contrast to traditional individual retirement accounts, Roth IRAs do not have Required Minimum Distributions. If you do not want to take out money at age 72, you are not required to.

There is also no age limit for contributions. As long as you have eligible income, you can contribute to a Roth IRA.

However, there are income limitations for Roth individual retirement accounts. For single filers whose Modified Adjusted Gross Income (MAGI) is between $125,000 to $140,000 in 2021 and couples filling jointly making between $198,000 to $208,000 in 2021, contributions are phased out. If you make more than that, you cannot contribute to a Roth IRA.

SEP IRA (Simplified Employee Pensions)

SEP IRAs are individual retirement accounts that allow self-employed and small-business owners to contribute to traditional IRAs (SEP-IRAs) set up for themselves or their employees. They are designed for people who aren’t otherwise eligible for employer-sponsored retirement plans or small business owners who cannot afford to invest in full 401(k) packages for each of their employees. Not every small business can set up a SEP plan. The compensation limit for a business to be allowed to set up a SEP IRA in 2021 is $290,000.

SEP IRAs set up by self-employed people generally have the same rules for contributions and withdrawals as traditional IRAs, so the contributions are generally tax-deductible, and investments grow tax-deferred. 

However, if your employer sets up a SEP IRA for you, your employer contributes for you, and your employer can deduct the contributions. You are not allowed to contribute to this SEP plan, and any withdrawals from it will be taxed at your income tax rate during your retirement. Contributions are immediately 100% vested. Account owners can select their investments themselves from the options provided by the plan.

In 2021, the contributions are limited to the lesser of 25% of compensation or $58,000, and there is no catch-up contribution at age 50+. SEP IRAs require that business owners who contribute to themselves make proportional contributions for each eligible employee. 

SEP IRAs do require minimum distributions beginning at age 72. 

SIMPLE IRA (Savings Incentive Match PLan for Employees)

SIMPLE IRAs provide small employers with fewer than 100 employees a simplified, less costly method to contribute toward their employees and their own retirement savings. Like Traditional IRAs and SEP IRAs, SIMPLE IRA contributions are tax-deductible, and earnings are tax-deferred. 

Employers set up SIMPLE IRAs for their employees and themselves. Unlike SEP IRAs in which employees themselves are not allowed to make contributions, SIMPLE IRAs offer employees the option to contribute to their account. Employers, however, are required to make contributions for their employees. 

In 2021, the employee contribution limit is $13,500, and the catch-up contribution for those age 50+ is $3,000.

The employer must contribute to their employees SIMPLE IRA every year either a 2% non-elective contribution for each eligible employee or a matching contribution up to 3% of the employee’s compensation (not limited by the annual compensation limit). All contributions, employee and employer, are immediately 100% vested.

Rollover IRA

A Rollover IRA is an account that allows for the transfer of assets from former employer-sponsored retirement plans such as 401(k)s and 403(b)s into a traditional IRA. The goal of a Rollover account is to maintain the tax-deferred status of retirement investments. There is no limit to the amount that can be rolled over.

There are different ways you can transfer assets to a rollover individual retirement account. The preferred way is a direct rollover because it does not trigger any taxes. A direct rollover is when your former employer’s plan administrator moves your retirement assets directly to the rollover IRA account. A direct rollover avoids that the Internal Revenue Service will withhold 20% of your assets. 

When the assets are transferred directly to you, the former employee, the rollover is considered an indirect rollover. You then have 60 days to transfer the funds to another eligible retirement account. 20% of the transferred assets may be withheld by the IRS and cannot be recovered until you file your tax return.

How to Open a Traditional or Roth IRA

For many people, an IRA is an important part of their retirement planning strategy. Opening an IRA is pretty simple, but before you do, you have to make some important decisions.

What type of investor are you?  

Compared with employer-sponsored retirement plans, IRAs offer a much wider variety of investment options. If you are an experienced investor, understand the differences in investment options, and are the hands-on type, making decisions on what to invest in should not be too difficult. Opening up a low-cost online brokerage account will be the way to go. Please make sure you pay attention to the fees and commissions charged and the brokerage’s customer service availability and quality. 

On the other hand, If you are a first-time investor or do not have the time or knowledge, you might need some help with your investment decisions. A great low-cost option is to open up a Robo-advisor account, which is an online computerized investment manager that will do all the hard work for you. It will ask you what your goals are and your risk level and then select investments that match your goals. It will even rebalance your portfolio over time. All the hard work will be done for you! Make sure you pick a Robo-advisor with low management fees, preferable below 0.40%

Asset allocation and your age

If you have decided to do it yourself and open a brokerage account, you will have to decide how you want to divide your money among different assets. Your preferred risk level and your age should be taken into consideration. The older you are, the less risk you should take. Generally, the percentage you invest in stocks should go down when you age.

A good option for investors that do not have a lot of investing experience would be to invest in a few ETFs and index funds. They are low-cost, low-risk options for your portfolio and will offer good diversification. Another good option could be to invest in a managed portfolio such as a target-date fund. A target-date fund is an investment fund that automatically changes the risk level of your investments from high-risk, high-reward to low-risk, low-reward options as you get closer to retirement.

If you are more experienced, you can include individual stocks and other asset classes such as commodities and futures in your IRA.

Hire a financial advisor if needed

In some cases, hiring a financial advisor is a great option. For example, it might be a good idea to get some professional help if you have several different retirement accounts. A financial advisor can provide a qualified analysis of your financial situation and let you know where you stand regarding investment capital and financial output. 

The advisor will also recommend the optimum schedule for saving and investing your future assets. Your financial advisor will help you determine the percentage of your annual contributions. From there, your IRA contributions can be deducted from your paychecks and deposited into your retirement account regularly.

Advantages of an IRA

Investing in a traditional or Roth IRA account has several advantages.

Easy and cheap to open – It is easy to open up a traditional or Roth individual retirement account without any professional help. You can use an online low-cost brokerage and be ready to go in less than 15 minutes. You can also open an individual retirement account at most banks, credit unions, and investment firms.

Investment gains accumulate on a tax-deferred basis – No taxes have to be paid on the dividends or capital gains that the investments in traditional and Roth individual investment accounts earn until distribution during retirement. Many retirees will be in a lower tax bracket after retirement, so having taxes deferred is beneficial. No taxes apply to qualified distributions of earnings in Roth IRAs (over 59½ and have held the account for more than 5 years).

Reduce your taxable income – IRA contributions to a traditional IRA account are made with pre-tax dollars. This means the amount contributed can be deducted from your taxable income in most cases, although certain limitations exist. This can potentially put you in a lower tax bracket. 

Rollover IRAs – Rollover IRAs are a destination when transferring an employer-sponsored retirement plan such as a 401(k) after leaving your employer. Investments in a rollover IRA will keep your tax-deferred status.

Wide variety of investment options – Most IRAs offer you thousands of investment options, including certificates of deposits, stocks, bonds, mutual funds, exchange-traded funds (ETFs), and more. This makes it possible to customize your portfolio to meet your financial needs, risk profile, and retirement goals.

SIPC protection (Securities Investor Protection Corporation) – If you have a Roth IRA and a traditional IRA at the same institution, SIPC protection treats them as separately insured accounts. It provides a total of up to $1 million in protection or $500,000 on the Roth account and $500,000 for the traditional IRA. SIPC insurance for brokerage firms is similar to FDIC protection for bank failures.

Disadvantages of an IRA

Low contribution maximums – The biggest disadvantage to an IRA is the low contribution limit. $6,000 a year, $7,000 for those over 50, is not very much money, especially if you open an IRA account later in life. 

Income limits – People who make above a certain amount of money are not allowed to contribute to an IRA. The later in life you start contributing to an IRA, the more chance your income is higher and that you might not be allowed to contribute.

Penalties for early withdrawal – Retirement age is considered 59½ for any retirement account. If you need to withdraw your money earlier in case of an emergency, you generally will be charged a 10% penalty fee on the amount you withdraw. If you withdraw it from a traditional individual retirement account, you will also owe income tax on that money. In some cases, the penalty might be waived. For example, if the money will be used for eligible medical expenses, the downpayment on your first home, or disability.

Required Minimum Distribution – In the case of a traditional IRA, you do not have to take withdrawals until you reach age 72. After age 72, your RMD is the minimum amount you must withdraw from your account each year. Roth accounts do not have RMDs.

What Happens When You Pass Away?

IRAs function similarly to bank accounts and other investment accounts after you die. They hold money in the name of the IRA owner. The owner can designate their spouse, children, or other people as beneficiaries. They can even name a trust as a beneficiary. This way, there is a clear understanding of what will happen with the IRA after the owner passes away.

IRAs are not subject to probate unless they are payable to an estate or unless no beneficiary is named. Therefore, It is important when opening an IRA to designate your desired beneficiaries right away, so your assets do not get stuck in probate and are protected even after you pass.

Conclusion

When thinking of potential retirement income, most people think of their Social Security benefits. However, Social Security is only designed to cover part of your retirement income. Some people will also get pension income from a former employer. However, these days, many people have to save money on their own, using individual and/or employer-sponsored retirement plans like a 401(k) or 403(b) to create a stream of income that will help them have their dream retirement. 

For many people, their employer’s retirement plan, such as a 401(k), is the only retirement plan they have. However, for people who do not have access to one, an IRA account is the perfect way to start saving for retirement. In addition, IRAs can be a good option for people who have maxed out their 401(k) contributions. 

IRAs have tax advantages and offer a wide variety of investment options. Earnings in an IRA account grow tax-deferred, which helps you build wealth over time. The earlier you start investing in an IRA, the better. That’s because time is an important factor when it comes to compound growth. However, keep in mind that you can always contribute to an IRA later in life.

IRAs might not be the right option for everyone. The circumstances in people’s lives dictate whether an IRA is a good idea and the type of IRA that would be best. For example, if you have a 401(k) and your employer offers a company match, you should always contribute the amount you need to get the full company match as this is basically free money. You also have to be able to afford an IRA contribution. The extra money you have might be better spent paying off high credit card debt or building your emergency fund than putting money in an IRA.

Before opening an IRA account, always consider the costs involved, the tax implications, and when you plan on taking the distributions.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.