Investing
IRAs
Your Individual Retirement Account
Individual Retirement Accounts (IRAs) are a
cornerstone of retirement planning, offering various tax advantages
to encourage saving for the future. Understanding the different
types of IRAs, their benefits, and the rules governing them can help
individuals make informed decisions to secure their financial
future.
Types of IRAs
There are several types of IRAs, each with its
own set of rules and benefits. The most common types are Traditional
IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.
Traditional IRA
A Traditional IRA allows individuals to
contribute pre-tax dollars, which can grow tax-deferred until
withdrawal during retirement. Contributions may be tax-deductible,
depending on the individual's income and participation in an
employer-sponsored retirement plan. Withdrawals are taxed as
ordinary income, and early withdrawals before age 59½ may incur a
10% penalty.
Roth IRA
A Roth IRA is funded with after-tax dollars,
meaning contributions are not tax-deductible. However, the earnings
grow tax-free, and qualified withdrawals during retirement are also
tax-free. Unlike Traditional IRAs, Roth IRAs do not have required
minimum distributions (RMDs) during the account holder's lifetime,
providing more flexibility in retirement planning.
SEP IRA
A Simplified Employee Pension (SEP) IRA is
designed for self-employed individuals and small business owners.
Contributions are tax-deductible and can be a significant percentage
of the participant's income, providing a way to save more for
retirement. The contributions made by employers to SEP IRAs are
tax-deductible, and the earnings grow tax-deferred until withdrawal.
SIMPLE IRA
A Savings Incentive Match Plan for Employees
(SIMPLE) IRA is suitable for small businesses with fewer than 100
employees. Both employers and employees can contribute to a SIMPLE
IRA, with the contributions being tax-deductible. The earnings grow
tax-deferred, and withdrawals during retirement are taxed as
ordinary income.
Contribution Limits
The IRS sets annual contribution limits for
IRAs, which can change from year to year. For 2023, the contribution
limit for Traditional and Roth IRAs is $6,500, with an additional
catch-up contribution of $1,000 for individuals aged 50 and older.
SEP and SIMPLE IRAs have higher contribution limits, with SEP IRAs
allowing contributions up to 25% of compensation or $66,000,
whichever is less, and SIMPLE IRAs permitting contributions up to
$15,500, with a catch-up contribution of $3,500.
Eligibility and Income Limits
Eligibility to contribute to IRAs and the
ability to deduct contributions or make Roth IRA contributions
depend on income levels and tax-filing status. For instance, in
2023, single filers with a modified adjusted gross income (MAGI) of
$138,000 or less can contribute to a Roth IRA, while those with a
MAGI between $138,000 and $153,000 are eligible for reduced
contributions. Married couples filing jointly have different income
thresholds.
Tax Considerations
The tax treatment of IRA contributions and
withdrawals is a critical factor in retirement planning. Traditional
IRA contributions may be tax-deductible, reducing taxable income in
the year of contribution. However, withdrawals are taxed as ordinary
income. Roth IRA contributions are made with after-tax dollars, so
they do not reduce taxable income, but qualified withdrawals are
tax-free.
Required Minimum Distributions (RMDs)
Traditional, SEP, and SIMPLE IRAs require
account holders to start taking RMDs at age 72. The RMD amount is
calculated based on the account balance and the IRS life expectancy
table. Roth IRAs do not have RMDs, allowing the account to grow
tax-free for a longer period.
Early Withdrawals and Penalties
Withdrawing funds from an IRA before age 59½
typically incurs a 10% early withdrawal penalty, in addition to
ordinary income tax on the withdrawn amount. However, there are
exceptions to this penalty, such as using the funds for qualified
higher education expenses, first-time home purchases (up to
$10,000), or significant medical expenses exceeding 7.5% of adjusted
gross income.
Beneficiaries and Inheritance
IRAs can be inherited by beneficiaries, and the
tax treatment of inherited IRAs depends on several factors,
including the relationship to the deceased and the type of IRA.
Non-spouse beneficiaries must generally take distributions within
ten years of the account holder's death, while spouse beneficiaries
have more options, such as treating the IRA as their own or rolling
it into their existing IRA.
Summary
Traditional IRAs offer tax-deferred growth,
meaning that contributions may be tax-deductible, but withdrawals in
retirement are taxed as ordinary income. Roth IRAs, on the other
hand, allow for tax-free growth and tax-free withdrawals, provided
certain conditions are met. Contributions to Roth IRAs are made with
after-tax dollars, so they do not offer an immediate tax deduction.
Page Last Updated: 20 March 2025