Geeky Insight:

What is an Individual Retirement Account (IRA)? How Do IRAs Work?

DollarGeek's goal is to help you make the best financial decisions. To help us do this, many or all of the products featured here are from our partners. However, this doesn’t influence our evaluations or ratings.
Written By: DollarGeek

Over one-third of American households own an individual retirement account (IRA).

Individual retirement accounts or IRAs provide a tax-efficient option for retirement savings. There are different types of IRAs, with each having its specific eligibility criteria, contribution deadline, and contribution limits.

This post provides a primer into different types of individual retirement accounts, advantages of various retirement plans, and a step-by-step guide for opening a retirement account.

What is an IRA?

An individual retirement account (IRA) is a tax-advantaged retirement instrument that allows individuals with earned income to make tax-deductible contributions to their accounts. Individual retirement accounts are tax-deferred accounts, which means your contributions are tax-deductible, but you will have to pay taxes on qualified withdrawals at the time of distribution only, depending on your tax bracket.

What are the different types of IRAs?

Traditional IRAs

Traditional IRAs are among the most popular retirement accounts. Any individual with earned income (salaried or self-employed) can open a traditional IRA. Any contributions you make to an IRA provide tax-deductions, depending on your income levels, and tax-deferred growth.

For small business owners, you can open an employer-sponsored IRA for your eligible employees and start contributing in accordance with their compensation benefits.

  • Eligibility: Any individual or self-employed professional with earned income can open a traditional IRA.
  • Annual contribution limits: $6,000 (plus a catch-up contribution of $1,000 for those above 50 years.)
  • Tax-deductions: Any contributions you make to an IRA are tax-deductible, depending on your modified adjusted gross income.
  • Withdrawals rules: You can take distributions after reaching the qualified retirement age. In the case of early withdrawals, the IRS will treat distributions as taxable income. These funds will be subject to an additional early-withdrawal penalty of 10%.
  • Investment options: Investment choices may vary depending on your IRA. Most employer-sponsored IRAs are managed by third-party custodians, providing a limited range of investment options. If you choose a self-directed IRA, you can add a variety of investments to your plan, including stocks, bonds, mutual funds, precious metals, and even real estate.

Best IRA Providers

Provider

Rating

Minimum

Commission/Fee

LEARN MORE

(5.0)

$0

0%

management fee

(5.0)

$0

$0

Roth IRAs

Roth IRAs are retirement accounts that allow plan participants to contribute after-tax dollars to their retirement plan. A critical difference between a traditional IRA and a Roth IRA is their tax treatment. When contributing to a Roth IRA, you pay taxes upfront, but there are no taxes on qualified distributions. On the contrary, a traditional IRA provides an upfront tax-break, but your distributions are taxable.

  • Eligibility: Roth IRAs have strict eligibility requirements.

Check these eligibility terms before you contribute to a Roth IRA.

Tax Status

MAGI

Eligible Contributions

Singe, Head of Household, Married filing separately (You didn’t live with your spouse anytime during the year) Less than $125,000 Contributions up to the limit
$125,000 or above but less than $140,000 Reduced contributions
$140,000 or more No contributions
Married, couples filing jointly, or widower (qualifying) Less than $198,000 Contributions up to the limit
$198,000 or above but less than $208,000 Reduced contributions
$208,000 or above No contributions
Married filing separately, and you lived with your spouse in the past year. Less than $10,000 Reduced contributions
$10,000 or more No contributions

Source: IRS (2021); MAGI (Modified adjusted gross income)

  • Annual contribution limits: $6,000 (plus a catch-up contribution of $1,000 for those above 50 years.)
  • Withdrawals rules: Roth IRAs have different withdrawal rules in comparison to a traditional IRA. 

You can withdraw your contributions from your Roth IRA at any time with no penalties or tax burden. However, when it comes to withdrawing earnings or capital gains on your contributions, the 5-year rule applies.

Age of account holder 5-Year Rule Applicable taxes or penalties on withdrawals
Less than 59 ½ years Yes Income taxes plus a 10% penalty on earnings, unless you have a qualified exception to avoid both.
Less than 59 ½ years No Income taxes plus 10% penalty on earnings, but chances of avoiding penalty in case of a qualified exception
Older than 59 ½ years Yes No taxes or penalties
Older than 59 ½ years No Tax on earnings without any penalty

There are no required minimum distributions for Roth IRAs, unlike traditional IRAs that require you to withdraw the least minimum distributions after reaching 72 (70 ½ if you reach 70 ½ before January 1, 2020). 

  • Investment options: Roth IRAs come with traditional investment choices, including stocks, mutual funds, bonds, and fixed-income deposits. However, if you choose a broker that provides self-direct Roth IRAs, you can invest in alternative investments in addition to your traditional investment options.

SIMPLE IRA

A SIMPLE, Savings Incentive Match Plan for Employees, IRA is a retirement plan for small businesses. Under a SIMPLE IRA, the business owner either makes a 2% non-elective contribution or a 3% matching-contribution of the employee’s salary to the plan.

SIMPLE IRAs are popular among small businesses because of their limited paperwork requirements, low maintenance and establishment expenses.

  • Eligibility: Small businesses with 100 or fewer employees can establish SIMPLE IRAs. Employers, as well as employees, can contribute to a SIMPLE IRA, depending on the structure.

The employer can set specific eligibility criteria for participation and may even exclude employees who receive these benefits through a union.

  • Annual contribution limits: Employers have to make 2% non-elective contributions or 3% matching-contributions to the plan. The annual contributions for employees max out at $13,500, along with a catch-up contribution of $3,000 for those above 50 years.
  • Withdrawals rules: Early withdrawals from a SIMPLE IRA come with a penalty of 10% to 25%, along with regular income taxes on the withdrawn amount.
  • Investment options: Most SIMPLE IRAs are managed by leading financial brokerages or professional management firms (Vanguard, Fidelity), which limits investment options to traditional investment choices.

SEP IRA

A Simplified Employee Pension (SEP) IRA is a retirement plan for small business owners, sole proprietors, corporations, and partnerships. SEP IRAs are famous because of their higher contribution limits in comparison to traditional IRAs, ease of establishment and lower maintenance cost.

In terms of flexibility, SEP IRAs allow employers to skip contributions during challenging periods. Employees above 21 years with a work history of three years and annual compensation above $600 qualify for SEP IRA contributions.

  • Eligibility: Sole proprietors, partnerships, corporations are eligible for SEP IRA plans.

In the case of employees, the eligibility criteria involve:

  • 21 years or older
  • Work history of three years or more
  • Annual compensation exceeding $600.
  • Annual contribution limits: 25% or employee compensation or $58,000, whichever is lesser. The annual compensation limit for contributions is set at $290,000 for 2021.

SEP IRAs do not offer catch-up contributions.

For sole proprietors, they can contribute 25% of profits minus their SEP contributions. Here is what the IRS recommends for calculating SEP IRA contributions.

  • Withdrawals rules: The same rules apply to SEP IRAs as that of a traditional IRA when it comes to withdrawals.
  • Investment options: SEP IRAs are managed by plan sponsors or third-party custodians, which investment options are limited to conventional investment instruments.

What are the benefits of saving money in IRAs?

An individual IRA holds several benefits over checking accounts, CDs, or money-market accounts when it comes to saving money for retirement.

  • Tax deductions: Your IRA contributions provide an instant tax deduction, allowing you to reduce your annual taxable income. This could be a huge benefit for small businesses as IRA contributions allow them to lower their taxable income while providing additional benefits to their employees.
  • Tax-deferred growth: Any contributions you make to an IRA enjoy tax-deferred growth. Your investments grow in a tax-free environment, benefitting from compound growth.
  • Roth IRA offers tax-free withdrawals. If you establish a Roth IRA and contribute after-tax dollars, your withdrawals become tax-free. In short, you will reap capital gains with no tax liabilities.
  • Catch-up contributions: A traditional IRA, SIMPLE IRA and Roth IRA offer catch-up contributions for plan owners, allowing those above 50 years contribute more money towards retirement savings.

How to open an IRA?

If you are ready to open an IRA, you can do so through a brokerage, financial advisor, or robo advisors.

  • Choose a broker for your IRA. You can choose a traditional IRA provider, Roth IRA provider, or a robo advisor for your IRA.
  • Provide necessary documents. The documents you need to set up your IRA varies depending on the type of IRA.
  • Fund your IRA through contributions or rollover. You can add funds to your IRA through regular contributions or IRA rollover. Here is a chart from the IRS for rollovers.
  • Take care of the maintenance of the IRA.

Check out some of the Best IRA Providers

Provider

Rating

Minimum

Commission/Fee

LEARN MORE

(5.0)

$0

0%

management fee

(5.0)

$0

$0