Individual Retirement Account Benefits and Features

An individual retirement account (IRA) provides significant advantages over a regular taxable account when it comes to saving for retirement. Depending on the type of account, you can benefit from tax-deferred or tax-free growth, which allows your money to compound more quickly. IRAs are best for long-term savings timelines and aren’t meant for withdrawals until the account holder reaches a specific age.

Key Takeaways

Individual retirement accounts, unlike employer-sponsored plans such as 401(k)s, are individually opened and managed, offering greater investment flexibility and choices.

There are various types of IRAs, including traditional IRAs, Roth IRAs, SEP IRAs and SIMPLE IRAs.

Funds in an IRA typically cannot be withdrawn before age 59.5 without facing tax penalties.

What Is an Individual Retirement Account?

An Individual Retirement Account (IRA), also known as an Individual Retirement Arrangement, is a tax-advantaged account designed to help individuals save for retirement. Unlike employer-sponsored plans like 401(k)s, individual retirement accounts are opened and controlled by individuals, allowing for more investment choices.

An individual retirement account allows you to contribute a portion of your income each year and let it grow tax-deferred or tax-free.

Types of IRAs

Individual retirement accounts allow for contributions to be made with either pre-tax or after-tax dollars, depending on the type of IRA.

Here are the main types of IRA accounts available:

IRA Account	What It Is	Key Benefits
Traditional IRA	A tax-deferred retirement account where contributions are often tax-deductible, and investments grow tax-deferred until withdrawal in retirement.	Tax-deductible contributions, tax-deferred growth.
Roth IRA	An account where contributions are made with after-tax dollars.	Qualified withdrawals in retirement are tax-free.
SEP IRA	Designed for self-employed individuals and small business owners, allowing for higher contribution limits than traditional IRAs.	Higher contribution limits, tax-deferred growth.
SIMPLE IRA	Suitable for small businesses with 100 or fewer employees, offering tax-deferred growth and employer contributions.	Employer contributions, tax-deferred growth.

WHAT IS AN IRA ROLLOVER?

An IRA rollover refers to the process of moving eligible distributions from one retirement account into an IRA tax-free. For example, if you leave an employer offering a 401(k) plan, you can roll over those 401(k) assets into a traditional IRA rather than cashing out and paying taxes.

This allows you to maintain the tax-advantaged status of your retirement savings as you transition between jobs or consolidate accounts.

How IRAs Work

Individual retirement accounts can be powerful retirement savings vehicles that provide tax advantages and investment flexibility. Understanding their rules and how they work will help you maximize your contributions and grow your retirement savings.

Contribution Limits

Contributions are the amounts you deposit into your IRA accounts annually. You should understand the contribution limits to maximize your retirement savings while avoiding penalties.

For 2024, the contribution limit for traditional and Roth IRAs is $6,500, an increase from $6,000 in 2023. If you're 50 or older, you can make an additional $1,000 catch-up contribution, bringing your annual total to $7,500.

It’s important to know that your ability to contribute to a Roth IRA may be limited based on your filing status and modified adjusted gross income (MAGI).

Roth IRA Allowable Contribution Conditions for 2023 (IRS)

Filing Status	Modified AGI	Allowable Contribution
Married filing jointly or qualifying widow(er)	Less than $218,000 More than $218,000 but less than $228,000 More than $228,000	Up to the limit Reduced amount None
Married filing separately and you lived with your spouse at any time during the year	Less than $10,000 More than $10,000	Reduced amount None
Single, head of household or married filing separately, and you did not live with your spouse at any time during the year	Less than $138,000 More than $138,000 but less than $153,000 More than $153,000	Up to the limit Reduced amount None

Source: IRS Amount of Roth IRA Contributions

WHAT HAPPENS IF YOU CONTRIBUTE OVER THE LIMIT?

Contributing more than the annual limits to your IRA can lead to penalties. If your IRA contributions exceed the limit, the excess amount is subject to a 6% tax per year for as long as it remains in your IRA. To avoid this 6% tax, you must withdraw the excess contributions and any earnings they generated by the due date of your tax return for that year.

If you realize you've over-contributed, act promptly to remove the excess amount and any associated earnings to avoid the 6% tax.

Deduction Limits

Deductions don’t apply to Roth IRAs since these contributions are made with after-tax dollars. However, with traditional IRAs, you may be eligible for an IRA tax deduction, reducing your taxable income for the year.

The ability to claim a traditional IRA tax deduction depends on your income level and whether you or your spouse is covered by a retirement plan at work. If you are covered by an employer plan, your deduction may be limited or phased out based on your filing status and modified adjusted gross income.

Deduction Limits If You Have a Retirement Plan at Work in 2023 (IRS)

Filing Status	Modified AGI	Allowable Deduction
Single or head of household	$77,000 or less Between $77,000 and $87,000 $87,000 or more	Full Partial None
Married filing jointly or qualifying widow(er)	$123,000 or less Between $123,000 and $143,000 $143,000 or more	Full Partial None
Married filing separately	Less than $10,000 $10,000 or more	Partial None

Source: IRS 2023 IRA Deduction Limits

Deduction Limits If You Aren’t Covered by a Retirement Plan at Work in 2023 (IRS)

Filing Status	Modified AGI	Allowable Deduction
Single, head of household, or qualifying widow(er)	Any amount	Full
Married filing jointly or separately with a spouse not covered by a plan at work	Any amount	Partial
Married filing jointly with a spouse who is covered by a plan at work	$230,000 or less Between $230,000 and $240,000 $240,000 or more	Full Partial None
Married filing separately with a spouse who is covered by a plan at work	Less than $10,000 $10,000 or more	Partial None

Source: IRS 2023 Deduction Limits (Not Covered by Work Plan)

Distributions

A required minimum distribution (RMD) is an annual withdrawal the IRS mandates you take from your traditional, SEP or SIMPLE IRA once you reach age 72. Missing your IRA required minimum distribution deadline can result in a 50% excise tax on the amount not withdrawn. Your first RMD must be taken by April 1st of the year after you turn 72, and subsequent RMDs are due by December 31st annually.

Roth IRAs are exempt from RMD rules during the owner's lifetime. However, beneficiaries inheriting Roth IRA assets must take RMDs based on their life expectancy or the five-year rule.

To avoid steep penalties, understand and follow the IRA required minimum distribution regulations once you reach the applicable age.

CAN I TAKE EARLY DISTRIBUTIONS?

Early distributions from traditional IRAs before age 59.5 typically incur a 10% additional tax penalty unless you qualify for an exception. Some early IRA distribution exceptions include disability, higher education expenses, a first-home purchase and specific medical costs. To avoid the penalty, carefully review the reasons for allowable early withdrawal before prematurely tapping into your retirement funds.

The rules for early withdrawals in Roth IRAs are slightly different. You can generally withdraw your contributions (the amount you put into the Roth IRA) at any time without penalty, but withdrawals of earnings may be subject to taxes and penalties if taken before age 59.5 and before the account has been open for at least five years.

Why You Should Invest in an IRA

The many tax benefits of an IRA make it a compelling retirement savings vehicle. Here are a few reasons to invest in one:

Accessibility and Easy Setup

IRAs are widely available and can be opened with most financial institutions, making them easily accessible.

Ownership and Control

Unlike employer-sponsored plans, you own and control your IRA, giving you more flexibility and investment choices.

Tax Advantages

IRAs offer tax-deferred or tax-free growth, depending on the type, helping your savings grow more efficiently.

Investment Flexibility

IRAs allow you to invest in a wide range of assets, from stocks and bonds to mutual funds and ETFs.

Portability

You can take your IRA with you when changing jobs.

WHAT ARE SOME COMMON MISTAKES PEOPLE MAKE WHEN MANAGING THEIR IRA INVESTMENTS AND HOW CAN THEY AVOID THEM?

One pitfall I see is that investors don’t pay enough attention to fees and expenses within IRA investments. Over decades, high fees can eat into your returns and hurt the growth of your investments.

Another mistake I often see is not rebalancing IRA portfolios regularly. As different assets outperform others, your target asset allocation can get skewed over time which can lead to more risk in your portfolio. I always recommend reviewing your allocations annually and making adjustments.

Finally, some investors don’t take full advantage of catch-up contributions when they’re over age 50. These catch-up contributions are a great way to help you boost your IRA savings in the years leading up to retirement.

How to Open an IRA

The steps to open an IRA are straightforward:

1
Choose an IRA type
Decide between a traditional or Roth IRA based on your financial situation and retirement needs.
2
Select an IRA provider
Research and compare providers, such as banks, brokerages or robo-advisors, to find one that meets your needs and preferences.
3
Open an account
Complete the account opening process and provide the necessary information.
4
Fund the IRA
Make your initial contribution, either through a lump sum or periodic transfers, staying within the annual contribution limits.
5
Invest your money
Allocate your money within your IRA across available investment options.

Other Retirement Savings Options

While an IRA offers tax and investment benefits, it's not the only retirement savings option available. The table below outlines other types of accounts to help build up your nest egg.

Retirement Savings Option	Description	Best for…
401(k) or 403(b)	Employer-sponsored plan allowing pre-tax contributions.	Those with access through work.
Taxable brokerage account	An investment account that allows you to buy and sell a variety of securities such as stocks, bonds and mutual funds. Unlike retirement accounts, there are no restrictions on when you can access the money.	Investors who have maxed out their tax-advantaged retirement accounts. People seeking flexibility in accessing their funds without penalties. People looking to save for either retirement or non-retirement goals.
High-yield savings account	FDIC-insured savings account with higher interest rates.	Low-risk, easily accessible cash reserves.
Certificates of deposit	Time deposits with fixed interest rates.	Conservative, low-risk fixed income.
Money market accounts	Interest-bearing accounts with check-writing access.	Holding cash needed in the short-term.
Annuities	Contract providing fixed/variable income stream.	Guaranteed lifetime income in retirement.

HOW DO YOU DECIDE WHETHER A TRADITIONAL IRA OR ROTH IRA IS BETTER FOR YOUR FINANCIAL SITUATION?

This is one of the most common questions I get from clients, and the answer depends on your specific circumstances. The key areas to consider are your current income tax bracket versus your expected tax bracket in retirement, whether you're eligible for the tax deduction on traditional IRA contributions and how soon you anticipate needing the funds.

For example, if you're in a lower tax bracket now than you expect to be in retirement, a Roth IRA may be better since you pay taxes upfront but enjoy tax-free withdrawals later. But if you're in a higher bracket currently, the upfront tax deduction of a traditional IRA could be more beneficial.

For those who don't qualify for the traditional IRA deduction due to income limits or lacking a workplace plan, the Roth becomes even more appealing.

However, keep in mind the maximum income limits for eligible Roth IRA contributions, which are based on Modified Adjusted Gross Income (MAGI). For 2024, single filers with MAGI up to $129,000 and married couples filing jointly with MAGI up to $204,000 can make the maximum Roth IRA contributions. Contribution limits phase out gradually beyond these thresholds.

Ultimately, this is a personal decision based on your unique tax situation, both now and in the future. I always recommend running the numbers for both scenarios to determine which will likely result in a higher after-tax income in retirement.

FAQ About Individual Retirement Accounts

Understanding retirement savings options can be confusing. MoneyGeek compiled quick answers to some frequently asked questions about retirement and IRA accounts.

How is a 401k different from an individual retirement account (IRA)?

A 401(k) is an employer-sponsored retirement plan that both the employee and employer can contribute to. An Individual Retirement Account (IRA) is opened by an individual through a bank, brokerage firm or financial institution.

Are there other types of retirement accounts?

Yes, there are several types of retirement accounts including 401(k), 403(b), 457 plan, SIMPLE IRA and SEP IRA, among others.

Can you have more than one IRA?

Yes, you can have multiple IRAs, including different types like Roth and Traditional IRAs. But the total contribution across all your IRAs can’t exceed the annual limit.

Can I have an IRA even if I’m under a retirement plan with my employer?

Yes, you can contribute to a traditional and/or a Roth IRA even if you participate in an employer-sponsored retirement plan.

Can I make multiple withdrawals to meet my required minimum distribution?

Yes, you can make multiple withdrawals from your IRA account to meet your required minimum distribution (RMD). Note that all of these withdrawals are included in your taxable income.

About Alvin Yam, CFP

Alvin Yam is a certified financial planner (CFP) with over 15 years of experience working with individuals and corporations. Before founding Paraiba Wealth Management, he was a director at HSBC and a financial consultant at Charles Schwab. Yam is MoneyGeek's expert consultant on wealth management and personal banking.

Yam earned his bachelor's degree in political science from the University of California, San Diego, and his Master of Business Administration from Loyola Marymount University.

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IRS. "Retirement topics - IRA contribution limits." Accessed May 23, 2024.
IRS. "401(k) limit increases to $23,000 for 2024, IRA limit rises to $7,000." Accessed May 23, 2024.
IRS. "2023 IRA Deduction Limits If You Are Covered by a Retirement Plan at Work." Accessed May 23, 2024.
IRS. "2023 IRA Deduction Limits If You Are NOT Covered by a Retirement Plan at Work." Accessed May 23, 2024.
IRS. "Required Minimum Distributions (RMDs)." Accessed May 23, 2024.
IRS. "RMD Comparison Chart." Accessed May 23, 2024.
IRS. "Exceptions to Tax on Early Distributions." Accessed May 23, 2024.
IRS. "IRA FAQs — Distributions (Withdrawals)." Accessed May 23, 2024.

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What Is an Individual Retirement Account? Benefits and Features