Individual Retirement Arrangements give individuals the opportunity to save money for retirement using a tax-advantaged plan. IRAs are offered by a wide variety of investment brokerages. You can choose do-it-yourself options, or you can go the automated route to meet your retirement goals with minimum effort.
For people who do not have access to workplace retirement plans, IRAs are a valuable savings tool. IRAs can even be useful if you have an employer-sponsored plan. So, let’s look at how these accounts work and how to decide which type of IRA is right for you.
What is an IRA?
An Individual Retirement Arrangement (IRA) is an account that is set up at a financial institution that allows individuals to save for retirement while getting certain key tax advantages. An IRA is designed to encourage people to save for retirement and grow those savings by investing the funds strategically.
How does an Individual Retirement Arrangement (IRA) work?
To open an IRA, you must be earning an income. You are allowed to contribute as much as you earn and no more. So, if you make $3,000 in a year, that’s the amount you can contribute and no more even though the maximum contribution amount is higher.
When you open an IRA, you get to select from a range of investment options available through your IRA provider. It’s important that you choose your IRA provider based on the types of investments you intend to make.
Whether you choose to invest in CDs, stocks, bonds or other investments is entirely up to you. You’re not limited as you often are with a 401(k). This allows you to take full control of how funds are allocated, which drives how your money is invested. IRAs also offer flexibility in adjusting investments. For example, you can move your money from individual stocks to bonds without incurring any capital gains taxes.
However, just because you can move your money around freely does not mean you can take it out early. After all, IRAs are designed to help you save for retirement. So, if you withdraw funds before the age of 59½, you incur taxes and a hefty 10% penalty.
You can use a traditional IRA as sole-retirement plan, or if you have access to a 401(k) you can use it to supplement your retirement plan.
Types of Individual Retirement Accounts (IRAs)
There are three main types of IRAs. Each one has its own advantages:
Traditional IRA
Who it’s best suited for: Traditional IRAs are ideal for workers who don’t have access to employer-sponsored retirement plans like a 401(k).
A traditional IRA is one of the most commonly used IRA. You are allowed to open and contribute to a traditional IRA until the age of 70½.
You can also contribute to a traditional IRA regardless of how much you make. There’s no income limit.
In most cases, contributions to traditional IRAs are tax-deductible. So, for example, if you put $5,000 into an IRA, your taxable income for the year would decrease by an equal amount. Your money grows on a tax-deferred basis, meaning you don’t pay taxes on your earnings. When you withdraw the money in retirement, it counts as part of your taxable income.
In 2022, your annual individual contributions to traditional IRAs cannot exceed $6,000 in most cases. If you are age 50 or older, you are able to contribute a little more ($7,000) because the difference is considered a catch-up contribution.
There are limits to how much of the tax deduction you can claim on your contributions. It’s based on your filing status and the adjusted gross income used to file your taxes.
Filing Status2022 Modified Adjusted Gross Income (MAGI)Deduction More than $68,000 but less than $78,000Partial deduction $78,000 or moreNo deduction
Married Filing Jointly$109,000 or lessFull deduction up to your contribution level More than $109,000 but less than $129,000Partial deduction $129,000 or moreNo deduction
Married Filing SeparatelyLess than $10,000Partial deduction $10,000 or moreNo deduction
Roth IRA
Who it’s best suited for: Roth IRAs are ideal for low to middle income workers.
Roth IRAs differ from traditional IRAs because you make contributions with money you’ve already paid with after-tax dollars. You don’t get any tax deductions either. But your money grows tax-free and you can withdraw money in retirement tax-free.
There are also no required minimum distributions as there are with 401(k)s and traditional IRAs. That means you don’t have to start withdrawing money until you want to withdraw it.
However, not everyone can contribute to a Roth IRA. The IRS sets income thresholds each year. So, if you make more than a certain amount, you will only be able to contribute a reduced amount or nothing at all to a Roth IRA. In 2022, the phaseout for single filers is between $129,000 and $144,000. For married couples who are filing jointly, the phaseout range is $204,000 to $214,000.
Much like traditional IRAs, annual individual contributions to Roth IRAs cannot exceed $6,000. But if you are age 50 or older, you can contribute $7,000.
| Filing Status | 2022 Modified Adjusted Gross Income (MAGI) | Contributions |
|---|---|---|
| Single or Head of Household | Less than $129,000 | Up to the limit |
| $129,000 to less than $144,000 | Reduced amount | |
| $144,000 or more | 0 | |
| Married Filing Jointly | Less than $204,000 | Up to the limit |
| $204,000 to less than $214,000 | Reduced amount | |
| $214,000 or more | 0 | |
| Married Filing Separately | Less than $10,000 | Reduced amount |
| $10,000 or more | 0 |
Rollover IRA
Who it’s best suited for: Rollover IRAs are best suited for employees with 401(k) accounts from past employers.
A rollover IRA is an account that lets people transfer assets from a former employer-sponsored retirement account to a traditional IRA. The purpose behind a rollover IRA is to maintain tax-deferred status on your assets. They are typically used to hold 401(k)s, 403(b)s, or any profit-sharing plan assets that can be transferred over from former employer-sponsored retirement accounts or any other qualifying plans.
So, by moving retirement plan assets through a direct rollover, you can avoid having 20% of your transferred assets withheld by the IRS. You can also move assets using an indirect rollover to take possession of your assets and place them into another eligible retirement plan within 60 days. Otherwise, you’ll end up paying income tax and penalties once the 60 days are up.
However, be aware that with indirect rollovers, 20% of your account’s assets may be withheld. They cannot be recovered until you file your annual tax returns.
How to open an IRA and maintain it
If you are looking to open an IRA, you or your spouse need to have earned income from working during that particular tax year. There are a number of places where you can open IRA accounts, such as brokerage firms, mutual fund companies, banks, as well as credit unions. Make sure to read the fine print and be aware of management fees, commissions, and minimum opening requirements to ensure you make out with the best deal.
If you are looking to open your own IRA, follow these steps:
- Start by going to your IRA provider’s website or if they have a branch location you can pay them a visit. From there, you’ll need to fill out your information.
- Then you can begin funding your account by transferring money from your bank account. You are also able to roll over a 401(k) into an IRA. But be aware that you could end up on the hook for an improper 401(k) rollover. There are also early withdrawal penalties.
- Finally, once your account is open and funded, you can decide on your portfolio’s allocation. This means you can choose how much risk you’re willing to take on. For example, you might choose a riskier investment and have two-thirds stock. Or you could be a safe investor who primarily sticks to cash equivalents and bonds. Once you’ve made your decision, begin investing!
How to use an IRA to its best advantage
Once you’ve opened your account, you’ll likely have questions or concerns about how to best manage or maintain your IRA. Here’s a starting point for how to best maintain an IRA account:
Review documents
When you receive documents from the brokerage or bank you’ve opened an IRA account with, always make sure to review them for accuracy. At least once a year, it’s a good idea to look at your records to make sure everything is in the proper order. From there, evaluate your investments to ensure they’re meeting your goals and expectations.
Meet with a plan advisor
Picking the right financial advisor is key to a successful portfolio. A financial advisor will help you reach financial goals, help you manage your investments and even offer you budgeting guidance. Some financial advisors will also offer you a free annual checkup with your plan. Take advantage of annual checkups so you can have an advisor reassess your portfolio, help you budget and rebalance when and where necessary.
Check in regularly on your investments
Whether you do it on your own or with the help of a financial professional, make sure to look at specific investments and decide if they still fit your goals. Sometimes you may consider taking on more risk when saving for retirement because it may be a few decades away. Or, say you have a short-term goal of purchasing a home within the next three to five years, you may take a more conservative approach with your investments.
Adjust allocations
The same way you go for regular checkups with your doctor or routinely change your car’s oil, you want to rebalance your portfolio. The goal here is to rebalance – i.e. selling some stocks and buying bonds, or vice versa – so that your portfolio’s asset allocation matches the level of returns you are aiming to achieve.
Set up AutoPay to directly contribute funds
It may be worth considering setting up an automatic investment plan to help directly contribute funds to your retirement account. An automatic investment plan lets transfer a set amount of funds from your paycheck into your investment account. That way you ensure you are investing wisely and are not tempted to keep those dollars from seeing the light of day.
If you don’t want to take the funds directly from your paycheck, you can also set up AutoPay yourself. Just set up an automatic monthly transfer from your bank account.
Anytime you get a raise or start getting extra income, revisit how much you’re investing in your IRA and considering increasing the amount. It’s easier to invest money you haven’t gotten used to spending yet.
IRA withdrawal rules
For IRA purposes, the standard age you can withdraw money from your IRA without incurring any penalties is 59½. This is the starting point for what is considered full retirement age for IRA accounts. Once you have reached this age, you can withdraw from your account for any reason without penalties.
If you are looking to withdraw from your IRA earlier, there are a few situations that you can do so:
- If you are a first-time homebuyer, you can withdraw up to $10,000.
- You can withdraw any amount for qualified higher-education expenses. So, in a way, an IRA can double as a college savings account.
- If you don’t have health insurance or if you have out-of-pocket medical expenses that are not covered by insurance, you can use your IRA distributions to cover these expenses penalty-free.
- You can also take out penalty-free distributions from your IRA to cover any health insurance premiums if you are unemployed.
- If you become disabled and are unable to work, you are able to withdraw money from your IRA without incurring the 10% penalty.
- If you inherit an IRA as a beneficiary, you won’t incur any 10% early withdrawal penalty fees.
- If you have unpaid federal taxes, your IRA will be used by the IRS to pay your bill. If the IRS levies money directly from your IRA, the 10% penalty will not be applied. But if you were to withdraw money from an IRA to pay the necessary taxes and avoid an IRS levy, you would be on the hook for that 10% withdrawal penalty.
- If you are a qualified Reservist – a member of the military reserve who called to active duty – you qualify for early withdrawal from your IRA without incurring early distribution penalties.
Outside of the reasons listed above, if you choose to withdraw money from your IRA before age 59½ years, you could face a 10% early withdrawal penalty, plus applicable taxes.
If you have a Roth IRA, you can withdraw funds equal to your contributions at any time because you have already paid taxes on those contributions. However, if your account has made investment gains, withdrawal rules apply to that specific portion.
Beneficiaries
A beneficiary is any person or entity that an owner chooses to receive the benefits of their retirement account or an IRA after they pass away. Generally, assets that are held in a deceased individual’s IRA must be transferred into a new IRA account in that beneficiary’s name.
Let’s dive deeper into the few differences between beneficiaries on traditional and Roth IRAs.
Inherited traditional IRAs
If a traditional IRA is inherited from a spouse, the surviving spouse has a few options:
- They can treat the traditional IRA as their own by designating themselves as the account owner.
- They can roll over the IRA into a traditional IRA through:
- A qualified employer plan
- A qualified employee annuity plan
- A tax-sheltered annuity plan
- A deferred compensation plan of a state or local government
- They can treat themselves as the beneficiary rather than treating the IRA as their own.
But if a traditional has been inherited by someone other than a spouse, the beneficiary cannot treat the IRA as their own. This means that a beneficiary cannot make any contributions to the IRA or even rollover any amount in or out of the inherited IRA.
However, a beneficiary is still capable of making a trustee-to-trustee transfer as long as the IRA is maintained in the deceased IRA owner’s name. By doing so, the beneficiary won’t owe any taxes on the assets in the IRA until he or she receives distributions from it.
Inherited Roth IRAs
Typically, a Roth IRA’s entire interest must be distributed by the end of the fifth calendar year after the owner’s passing. But it doesn’t have to be distributed if the interest can be paid over the lifetime of the designated beneficiary.
If the Roth IRA is paid as an annuity, the entire interest is payable before the designated beneficiary’s life expectancy. That means they’ll have to take out distributions before the end of the calendar year following the year of death.
If you have another Roth IRA, you cannot substitute distributions from that Roth IRA for these distributions. However, there is an exception. If both Roth IRAs are inherited from the same deceased person, then the distributions can be substituted.
And if the sole beneficiary happens to be the spouse, then they can choose to treat the Roth IRA as their own or they can choose to delay distributions until the deceased would have reached age 70 ½.
Tax reporting
Depending on your IRA investments, you may have to file tax returns. Here are the forms you would use with the IRS for your IRA investments:
Form 5498This form is filed by your IRA provider. There are no taxes due or paid.It reports your IRA contributions, Roth IRA conversions, the account’s fair market value, and the required minimum distributions that were taken.
| IRS Form | Purpose | What Does It Do |
|---|---|---|
| Form 5498 | This form is filed by your IRA provider. There are no taxes due or paid. | It reports your IRA contributions, Roth IRA conversions, the account’s fair market value, and the required minimum distributions that were taken. |
| Form 1099-R | This form is also filed by your IRA provider to the IRS. The amounts that have been distributed or converted are subject to tax. | It reports IRA distributions for the year, Roth IRA conversions, and any rollovers that are not direct IRA-trustee to IRA-trustee. |
Saver’s credit
The retirement savings contribution credit, or saver’s credit for short, is a tax credit for low-to-moderate income workers who save for retirement through a 401(k) or through an Individual Retirement Account. The tax credit is worth up to $1,000 or $2,000 if you are married and filing jointly.
To be eligible in 2022, individuals with adjusted gross incomes up to $34,000 who contribute to a retirement account can qualify for the saver’s credit. If you are the head of household, there is a higher saver’s credit income threshold ($51,000) in 2022. And if you are married, you can qualify for the credit if your household earns as much as $68,000 in 2022.
Pros and cons of IRAs
We’ve created a table to simplify the answer and help you weigh the pros and cons more efficiently.
Traditional IRAs
| Pros | Cons |
|---|---|
| Easy to start | Contribution limits |
| More investing options | Penalties for early withdrawals |
| Flexible options for allocations | Low contribution rate |
| Claim tax deductions | |
| IRAs are tax-deferred | |
| No income limits |
Roth IRAs
| Pros | Cons |
|---|---|
| Tax-free savings growth | There are income limits |
| No required minimum distributions | Maximum contribution rates are lower |
| No penalties for contribution withdrawals | |
| Tax-free withdrawals in retirement |
Is it better to have a 401(k) or an IRA?
IRAs and 401(k)s are two of the most popular retirement accounts around. An IRA is an account you open of your own accord, whereas a 401(k) is offered through an employer. You can have both an IRA account and a 401(k) at the same time as well.
With a 401(k), you get the benefit of an employer matching your contributions. Employers will match up to a percentage of your salary. For example, your employer might offer to match fifty cents for every dollar you contribution up to 6% of your annual salary.
Sources
https://www.irs.gov/instructions/i1099r
https://www.irs.gov/retirement-plans/individual-retirement-arrangements-iras
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
https://www.fidelity.com/building-savings/learn-about-iras/what-is-an-ira
