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Retirement

What Is An IRA? (Types of IRAs, Rules, and Eligibility)

Overview

  • An IRA is an individual retirement account. Anyone with earned income can contribute to a traditional or Roth IRA, even if they receive a 401k at work.
  • There are many types of IRAs, each one having different contribution limits, withdrawal rules, and tax treatments. The most common IRAs are the traditional and Roth IRAs. Business owners and self-employed individuals also have access to the SEP IRA and SIMPLE IRA.
  • A traditional IRA is funded with pre-tax dollars. Contributions are tax-deductible, but withdrawals in retirement are taxed as regular income.
  • A Roth IRA is funded with after-tax dollars. Contributions are not tax-deductible, but withdrawals in retirement are completely tax-free.
  • A SEP IRA is available for any self-employed individual or business owner with few employees. Contribution limits are much higher than a traditional or Roth IRA.
  • A SIMPLE IRA is a available for any business owner with fewer than 100 employees. It's a cheaper, simpler alternative to offering a 401k plan at your company.

What is an IRA?

IRA stands for Individual Retirement Arrangement, and is a tax-advantaged investment account available for anyone with earned income. They’re especially useful for people who don’t have access to an employer-sponsored 401k plan at work. 

There are many different types of IRAs, with the two most popular being the traditional and Roth IRA. There are also IRAs specifically designed for business owners, like the SEP IRA and SIMPLE IRA. These have higher contribution limits than regular IRAs, but you do need to meet additional eligibility rules.

Every IRA comes with different tax benefits, contribution limits, withdrawal rules, and eligibility requirements. Depending on the type of IRA you choose, you could either get immediate tax breaks when you contribute to your plan, or get tax-free withdrawals in retirement.

How does an IRA work?

IRAs are long-term savings accounts. Anyone with earned income can contribute to a traditional or Roth IRA, and you usually can’t withdraw money from it until you reach the age of 59½.

Money that gets invested in an IRA compounds tax-free. You don’t pay any taxes when you sell assets in your account for a profit. Instead, you can either choose to defer your taxes until retirement (with a traditional IRA) or pay taxes when you contribute but have tax-free withdrawals in retirement (with a Roth IRA).

Traditional vs Roth IRA

Whether you choose to contribute to a traditional IRA or a Roth IRA depends on what kind of tax advantage you’re looking for.

  • A traditional IRA is funded with pre-tax dollars. Your contributions are tax deductible, reducing your taxable income for the year. However, your withdrawals in retirement (when you reach the age of 59½) are taxed as regular income. With a traditional IRA, you’re essentially deferring your taxes until retirement.
  • A Roth IRA funded with after-tax dollars. You contribute with money that you already paid income taxes on. You don’t get any immediate tax breaks for contributing to a Roth IRA, but your withdrawals in retirement (when you reach the age of 59½) are completely tax-free. With a Roth IRA, you’re paying taxes upfront, but your nest egg is completely tax-free.

You can open a traditional or Roth IRA with most banks, robo-advisors, or brokerages. Even people who receive an employer-sponsored 401k plan at work are allowed to open and contribute to a Roth IRA.

IRA vs 401k

Both the IRA and 401k are retirement plans. The main difference is that a 401k is employer-sponsored, and an IRA is an individual account. If you don't work at a company that offers an employer-sponsored 401k, you cannot contribute to one. The only way to contribute to a 401k without an employer is to open a solo 401k, which is available to self-employed individuals with zero employees (excluding spouses). Anyone with earned income can contribute to an IRA, even those who receive a 401k at their work.

A 401k has higher contribution limits than a traditional or Roth IRA, but the investments options are much more limited. With a 401k, you usually only have about 8 to 10 different mutual funds to choose from within your plan. You typically cannot invest in things like individual stocks or alternative assets like real estate and cryptocurrencies.

A 401k will usually also have employer matched contributions, where the employer will make contributions to your 401k up to a percentage of your salary. For example, many companies will offer dollar-for-dollar employer matching, up to 3% to 6% of an employee's salary each year. Employer matching is almost considered as free money on top of yearly compensation. Because an IRA is not employer-sponsored, there is no employer match contributions.

Types of IRAs

There are many different types of IRAs. The most common are the traditional IRA and Roth IRA. Traditional and Roth IRAs are mostly the same, with the main difference between them being when they get taxed.

Account Contribution Limits Roth Pros Cons
SEP IRA $61,000 in 2022. $66,000 in 2023. No High contribution limits. No Roth option, and only employers can contribute.
Roth IRA $6,000 ($7,000 if age 50+) in 2022. $6,500 ($7,500 if age 50+) in 2023. Yes Withdrawals in retirement are tax-free, contributions can be withdrawn at anytime, no RMD. Small contribution limit.
Traditional IRA $6,000 ($7,000 if age 50+) in 2022. $6,500 ($7,500 if age 50+) in 2023. No Contributions are tax-deductible. Small contribution limit. High income earners cannot contribute.
SIMPLE IRA $14,000 ($17,000 if age 50+) in 2022. $15,500 ($19,000 if age 50+) in 2023. No Simple, cost-effective option for offering a retirement plan to employees. Contributions are tax-deductible. No Roth option, contribution limits are lower than a 401k.

Traditional IRA

Contributions to a traditional IRA are tax-deductible. For example, if you contribute $5,000 to a traditional IRA, this gets deducted from your taxable income for the year. If you made $50,000, your new taxable income would now be $45,000. You can get a tax deduction each year you contribute, and you don’t pay taxes until you reach the eligible withdrawal age of 59½. When you start taking distributions in retirement, it gets taxed as regular income.

Contribution limits: With a traditional, your contribution limits are $6,000 for 2022 and $6,500 for 2023. If you’re at least 50 years of age, you also get an additional $1,000 in catch-up contributions, bringing your contribution limits to $7,000 for 2022 and $7,500 for 2023.

Withdrawal rules: You're allowed to start taking qualified distributions starting at the age of 59½. Withdrawals are taxed as regular income.

Penalties for early withdrawals: Any withdrawals made before you turn 59½ are hit with a 10% penalty, plus income taxes on the amount drawn.

RMD: A traditional IRA has required minimum distributions. You must start taking distributions from your account each year when you reach the age of 72. You can view the RMD table to calculate your RMD amounts.

Eligibility rules: Anyone with earned income. There are no age or income limits. However, if your income is too high, you may not get a full tax deduction on your contributions:

If you have a retirement plan at work, your tax deductions can get reduced if your modified adjusted gross income (MAGI) is too high.

Traditional IRA tax deduction limits for 2022

  • If your MAGI is $68,000 or less, you get get a tax deduction up to the maximum traditional IRA contribution limit of $6,000 ($7,000 if age 50+).
  • If your MAGI is over $68,000 but less than $78,000, you'll get a partial tax deduction.
  • If your MAGI is over $78,000, you get no tax deduction.

Traditional IRA tax deduction limits for 2023

  • If your MAGI is $73,000 or less, you get get a tax deduction up to the maximum traditional IRA contribution limit of $6,500 ($7,500 if age 50+).
  • If your MAGI is over $73,000 but less than $83,000, you'll get a partial tax deduction.
  • If your MAGI is over $83,000, you get no tax deduction.

This only applies if you also have a day job where you receive a company 401k. You can calculate your modified adjusted gross income (MAGI) using Worksheet 1-1 in IRS Publication 590-A.

Roth IRA

The Roth IRA is simply a Roth version of the traditional IRA. Instead of your contributions being tax-deductible, you contribute with money that’s already been taxed. For example, if you contribute $5,000 to a Roth IRA and made $50,000 that year, your taxable income would still be $50,000. You don’t get any tax deductions when you contribute, but your withdrawals in retirement are completely tax-free. 

Contribution limits: A Roth IRA has the same contribution limits as a traditional IRA. You can contribute up to $6,000 ($7,000 if age 50+) for 2022 and $6,500 ($7,500 if age 50+) for 2023.

Withdrawal rules: With a Roth IRA, you're allowed to withdraw your contributions without penalties or taxes at any age, even if you're under the age of 59½. You're allowed to start taking qualified distributions of any earnings from your account when you're at least 59½ years old, and your Roth IRA is at least 5 years old. Since you already paid taxes when you contributed, withdrawals are tax-free.

Penalties for early withdrawals: There are no penalties or taxes for withdrawing your contributions. However, if you withdraw earnings from your account before the age of 59½, and before your account is at least 5 years old, you'll be hit with a 10% fee plus income taxes on the amount drawn. For example, if you contribute $10,000 to your Roth IRA and your account grows in value to $15,000, you can withdraw your $10,000 contributions at any time. To withdraw the $5,000 in earnings, you must wait until you're eligible for qualified distributions.

Eligibility rules: Anyone with earned income. The Roth IRA has income limits. If your income is too high, you cannot contribute to a Roth IRA.

Roth IRA income limits for 2022

  • If your income is $129,000 or less, you can contribute up to the maximum Roth IRA contribution limit of $6,000 ($7,000 if age 50+).
  • If your income is over $129,000 but less than $144,000, your contribution limit gets reduced.
  • If your income is over $144,000, you cannot contribute at all.

Roth IRA income limits for 2023

  • If your income is $138,000 or less, you can contribute up to the maximum Roth IRA contribution limit of $6,500 ($7,500 if age 50+).
  • If your income is over $138,000 but less than $153,000, your contribution limit gets reduced.
  • If your income is over $153,000, you cannot contribute at all.

If your income is too high, a workaround to the income limits is the mega backdoor Roth IRA.

SEP IRA

If you're a business owner or self-employed with zero or just a few employees, you may be eligible for a special kind of IRA, the SEP IRA. The SEP IRA stands for Simplified Employee Pension Plan and it has much higher contribution limits (over 10x higher) than a traditional or Roth IRA at $61,000 for 2022 and $66,000 for 2023. With a SEP IRA, you can only contribute as an employer business, which is counted by 25% of your income, and there is no Roth option. If you have employees who work for you, the IRS requires that you make equal percentage contributions to every employee. For example, if you contribute 15% of your compensation to your SEP IRA this year, you also have to contribute 15% of every employee's compensation to their SEP IRAs.

Contribution limits: The contribution limit of a SEP IRA is $61,000 for 2022 and $66,000 for 2023. There are no catch-up contributions for people 50 years of age or older with a SEP IRA. Employers can contribute up to 25% of their compensation up to the maximum contribution limit. The compensation you can use is capped at $305,000 for 2022 and $330,000 for 2023. There is no Roth option with a SEP IRA, contributions are tax-deductible and taxed as regular income when you withdraw in retirement.

Withdrawal rules: You can start taking qualified distributions from your account when you reach the age of 59½. Withdrawals are taxed as regular income, like a traditional IRA.

Penalties for early withdrawals: Any early withdrawals before the age of 59½ are hit with a 10% penalty, plus income taxes.

RMD: A SEP IRA has required minimum distributions. You must start making withdrawals from your account when you reach the age of 72.

Eligibility rules: Any business owner or self-employed individual with zero or few employees. If you have zero employees, you also qualify for the solo 401k, which has even more tax advantages than a SEP IRA.

A SEP IRA is a cost-effective way to set up a retirement plan for your company, but can get expensive if you have too many employees. If you have too many employees, but under 100, the better option could be a SIMPLE IRA. One thing to keep in mind, though, is that SEP IRA contributions are not mandatory each year, while a SIMPLE IRA has mandatory employer contributions.

SIMPLE IRA

SIMPLE IRA stands for Savings Incentive Match Plan for Employees, and is a retirement plan you can offer at your company if you have fewer than 100 employees. It's often regarded as the simpler, cheaper alternative to offering a full employer-sponsored 401k plan. The difference between a SIMPLE IRA and a SEP IRA is that employees are allowed to contribute to their own SIMPLE IRAs through elective deferrals. A SIMPLE IRA has a lower contribution limit than a SEP IRA, but can be more cost-effective for employers who have many employees. Like a SEP IRA, there is no Roth option, and contributions are tax-deductible.

Contribution limits: The contribution limit of a SIMPLE IRA is $14,000 for 2022 and $15,500 for 2023. Unlike the SEP IRA, a SIMPLE IRA has catch-up contributions. If you're over the age of 50, your contribution limit is $17,000 for 2022 and $19,000 for 2023.

Contribution options: Employee contributions are optional, but employer contributions are mandatory. Employers must either make matching contributions up to 3% of an employee's salary, or make non-elective contributions equal to 2% of an employee's salary, based on a maximum salary of $305,000 in 2022 and $330,000 in 2023. Employers choose how they'll contribute when they set up their plan. Employee and employer contributions are tax-deductible.

Withdrawal rules: You can start taking qualified distributions from your account when you reach the age of 59½. Withdrawals are taxed as regular income, like a traditional IRA.

Penalties for early withdrawals: Any early withdrawals before the age of 59½ are hit with a 10% penalty, plus income taxes. With a SIMPLE IRA, there's an additional 15% penalty if you make early withdrawals within the first two years of making your first contribution. For example, if you're under 59½ years old, and it's been less than two years since you made your first SIMPLE IRA contribution, you'll have to pay 25% in penalties, plus income taxes on the amount withdrawn.

RMD: A SIMPLE IRA has required minimum distributions. You must start making withdrawals from your account when you reach the age of 72.

Eligibility rules: Any business owner or self-employed individual with fewer than 100 employees. You can also open and contribute to a SIMPLE IRA if you have zero employees, but in this case, there are better options for you, like the solo 401k.

What can I invest in through an IRA?

An IRA is allowed to invest in any asset class, except for collectibles, life insurance, and any prohibited transactions with a disqualified person.

However, your investment options are limited to whatever your plan provider offers you when you set up your account. Most IRA providers will let you invest in individual stocks, mutual funds, bonds, and ETFs. If you want to invest in alternative assets like real estate, crypto, private equity, and venture capital, you'll need to open a self-directed IRA.

Any IRA can be self-directed. You can open a self-directed traditional IRA, a self-directed Roth IRA, self-directed SEP IRA, or a self-directed SIMPLE IRA. The only difference between a self-directed IRA and a regular IRA is that you're allowed to invest in alternative assets with a self-directed account, rather than being limited to just stocks, bonds, and mutual funds.

The downside is that most major banks and brokerages do not offer self-directed IRAs and you'll usually have to find a third party provider that specifically allows investments in the asset class you want to invest your money in.

Note: A self-directed IRA does not give you full checkbook control over your account. You don't get to make the investments yourself. You need a custodian to manage and administer your account for you. If you want to invest in something, you'll have to instruct your custodian to send the funds. This can make the investment process longer than you prefer, and could get expensive if your custodian charges transaction fees. For full checkbook control over your retirement account, you would need to open a checkbook IRA or a solo 401k.

How to open an IRA

To open a traditional or Roth IRA, all you need is any form of earned income and you can open an account at most banks, brokerages, robo-advisors, or credit unions.

To open a SEP IRA or SIMPLE IRA, you must be self-employed or a business owner with a few employees. There's no limit on the number of employees for a SEP IRA, but having to make equal percentage contributions for every employee could get expensive. With a SIMPLE IRA, you must have fewer than 100 employees to qualify.

Opening a SEP or SIMPLE IRA is fairly straightforward and is similar to opening a traditional IRA. You can do so with most banks and brokerages. However, the SEP and SIMPLE IRAs have additional reporting requirements to the IRS each year.

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