Individual Retirement Arrangements (IRA): Definition, Types and Benefits

A single egg in a nest with $100 bills.
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Individual retirement accounts are special financial accounts designed to help people save for retirement. Between their tax-advantaged characteristics and their access to a wide range of investments, they are an option favored by many Americans looking to generate long-term retirement savings. If you’re also looking for a way to build your nest egg, you might be wondering whether opening an IRA is the right option for you.

Read on to learn about common types of IRAs and the advantages they offer.

See: 5 Things You Must Do When Your Savings Reach $50,000

What Is an IRA?

IRAs are tax-advantaged retirement savings accounts. There are several types of accounts, each with its own eligibility rules and contribution limits. Some contributions are tax deductible. Some withdrawals may be tax-free.

IRAs are unique compared with traditional savings vehicles because they have market exposure. You can own stocks, mutual funds, exchange-traded funds and other securities in an IRA, which can help your account value compound quickly compared to savings accounts, CDs and money market accounts.

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The history of the IRA goes back to the 1960s and early ’70s. According to Forbes, companies like Studebaker were struggling to pay pensions to thousands of workers. In 1974, the crisis led Congress to enact the Employee Retirement Income Security Act. This law created new regulations for pensions and retirement plans like the IRA. A new era of how people funded retirement was soon underway. Saving for retirement became the responsibility of individuals, not employers. Few companies continued to offer pensions.

Benefits of IRAs

The obvious benefit of IRAs is that they allow people to save for retirement. Social Security benefits alone are typically not enough to provide people with an income during retirement. Without pensions, it’s up to individuals to save for their retirement themselves.

Return on Investment

IRAs provide better returns than traditional savings accounts — the average APY on a savings account is just 0.24% as of Nov. 21, 2022. This rate doesn’t come anywhere close to keeping up with inflation. Meanwhile, an IRA is essentially an open platform when it comes to investments.

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While you’re able to keep conservative investments like Treasury bills and CDs in your IRA, you can also buy speculative stocks, emerging market companies or other more aggressive options to boost long-term returns. Although these types of investments are not guaranteed, you can work in conjunction with a financial advisor to create a portfolio that balances your risk tolerance with your investment objectives, and that can potentially generate much higher returns on average than more conservative options.

Tax Advantages

IRAs are also tax-advantaged accounts. For traditional IRAs, contributions are usually tax deductible. You won’t have to pay taxes on any dollar you put into your IRA in a given year. You will, however, pay taxes on withdrawals.

Roth IRAs, on the other hand, do not provide tax-deductible contributions. Instead, qualified withdrawals and gains are tax-free. Over time, these tax advantages can add a significant amount of money to your account, as opposed to if you had to pay taxes on your interest, dividends and capital gains every year.

Pay Attention to the Rules

There are rules for how you can withdraw funds from IRAs. If you’re not careful, the IRS might charge you enormous fees and penalties. For example, if you withdraw funds before the age of 59 ½, you might have to pay taxes and a 10% penalty. The IRS allows some exceptions, as noted below.

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What Are the Types of IRAs?

There are several types of IRAs to choose from. The two most commonly known are the Traditional IRA and the Roth IRA, but they aren’t the only options. Each type has different characteristics and is suited for different situations. Here is an overview of some of the most common types.

Traditional IRA

Traditional IRAs are perhaps the most common type. In 2022, total annual contributions were limited to $6,000. This limit rises to $6,500 in 2023. The IRS has a provision that allows you to contribute up to an additional $1,000 per year if you’re age 50 or older. This boosts the IRA contribution limits for those 50 and older to $7,000 and $7,500 in 2022 and 2023, respectively. Contributions may be fully or partially tax deductible, depending on your filing status and income.

These limits do not apply to rollovers, which is when you withdraw funds from one IRA and put them into another. Generally, people perform rollovers when they want to change institutions or combine separate accounts.

The balance in your IRA will continue to grow on a tax-deferred basis until you take a distribution, also known as a withdrawal. Withdrawals from traditional IRAs are then taxed as income according to your tax bracket.

Roth IRA

Roth IRAs have the same contribution limits as traditional IRAs: up to $6,000 or $7,000 — for those 50 and over — in 2022, and $6,500 or $7,500 in 2023. However, some restrictions limit contributions based on income and filing status. For example, if your filing status is married filing jointly and you have a modified adjusted gross income greater than $214,000 in 2022, you cannot contribute anything to a Roth IRA. That limit rises to $228,000 in 2023.

The Roth IRA’s main advantage is that your balance generally grows tax-free and qualified withdrawals from the account are tax-free. This benefit can lead to significant long-term tax savings.

SIMPLE IRA

The Savings Incentive Match Plan for Employees IRA is a plan designed for small businesses with fewer than 100 employees. SIMPLE IRA plans are very similar to traditional IRAs and feature tax-deductible contributions. As the acronym suggests, they are simple to set up and operate.

There are some differences between the SIMPLE and traditional IRA. Employers must contribute to the SIMPLE IRA plan. Contributions from an employee can only come from their salary, limited to an annual total of $14,000 in 2022 and $15,500 in 2023.

SEP IRA

The Simplified Employee Pension plan is a retirement plan for businesses of any size. SEP plans have low administrative costs and are very easy to set up. Employers are the only ones allowed to contribute to these plans, up to the lesser of 25% of an employee’s salary or $61,000 in 2022 — $66,000 in 2023. Contributions and withdrawals are treated like a traditional IRA.

What Is an IRA Rollover?

An IRA rollover is an account that allows you to move money from one tax-advantaged account to another, such as an IRA to another IRA or a 401(k) to another 401(k), without triggering any tax consequences. This is a significant benefit, as other types of withdrawals from these types of retirement accounts can result in ordinary income taxes and early withdrawal penalties.

What Is an IRA Phaseout?

If either you or your spouse are covered by a retirement plan at work, the deductibility of IRA contributions begins to phase out once you’ve earned above a certain level of income. There are many permutations to this phaseout, and you should consult with your tax advisor for the most relevant figures for your personal financial situation.

However, if you are a single person covered by a retirement plan at work, your IRA contributions begin to lose deductibility once you reach $73,000 in adjusted gross income, with a total phaseout above $83,000. For joint filers, those numbers are $116,000 and $136,000, respectively.

What Are the Types of IRA Distributions?

While there are many types of IRA distributions, they are primarily considered either regular or premature. Regular distributions are made after age 59 ½, while premature ones are made earlier. For traditional IRAs, all distributions are taxed as ordinary income, while Roth distributions are tax-free.

For either type of IRA, taking money out before age 59 ½ generally triggers a 10% early distribution penalty. Some exceptions include death, disability, a Qualified Domestic Relations Order, a series of substantially equal payments, qualified higher education expenses and a qualified first-time home purchase of up to $10,000.

How To Get Started

Some brokers charge annual fees and commissions for your account, while others may have $0 annual fees and charge zero commission for purchases of securities like stocks, exchange-traded funds or mutual funds. Others may offer certain promotions and bonuses, such as a $200 cash bonus if you deposit $20,000 or some variation thereof. Do your research to decide which type of IRA is right for you and to find the best broker for you.

FAQ

  • Is an individual retirement account the same as a 401(k)?
    • An IRA is an individual retirement account. A 401(k), on the other hand, is a corporate retirement plan sponsored by a business. As 401(k) administration can be expensive, these types of plans are usually only offered by larger employers, although this is not always the case.
    • A 401(k) has higher contribution limits than an IRA, and it may also offer loans to participants. However, 401(k) plans usually have limited investment options, whereas IRAs are open to nearly any type of investment.
  • How does an individual retirement account work?
    • Like other retirement accounts, you deposit money into your IRA while you are working and earning an income. The deposited money is often used to invest in stocks, ETFs or mutual funds to grow rather than falling behind inflation. Then, after you retire, you can withdraw funds to cover your living expenses, since you are no longer earning an income.
    • Unlike employer-sponsored retirement plans, an IRA is an individual account.

John Csiszar contributed to the reporting for this article.

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About the Author

Scott Jeffries is a seasoned technology professional based in Florida. He writes on the topics of business, technology, digital marketing and personal finance. After earning his bachelor’s in Management Information Systems with a minor in Business, Scott spent 15 years working in technology. He's helped startups to Fortune 100 companies bring software products to life. When he's not writing or building software, Scott can be found reading or spending time outside with his kids.
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