What is an IRA? Everything you need to know

A closer look at what you need to know before opening an individual retirement account.

If you’re thinking about how you can save for retirement, individual retirement accounts, better known as IRAs, are worth considering. Almost anyone with earned income can open an IRA, which makes it different from a 401(k), which you can only participate in if your employer offers one. There are several different types of IRAs, each with its own requirements and features, but all offer important tax advantages that could help you save more for your future.

The most popular kinds of IRAs are traditional IRAs and Roth IRAs. The combined maximum yearly contribution to both accounts is $5,500 for 2018—or $6,500 if you will be age 50 or older at any time during the calendar year. Here’s what you need to know to help you choose an IRA.

What are traditional IRAs?

Traditional IRAs provide tax-deferred growth. This means your money grows tax-free until you begin taking distributions, at which point your withdrawals are taxed at your income tax rate. What’s more, contributions may be tax-deductible. For instance, if you make $40,000 per year and put $3,000 in a traditional IRA, you receive a deduction against your $40,000 of income.

For 2018, if you are an active participant in a workplace retirement plan, your contributions are at least partially deductible if your modified adjusted gross income is less than $73,000 if you are single or $121,000 if you are married and filing jointly. The income limits are higher if your spouse is an active participant in a workplace retirement plan but you are not. However, if neither you nor your spouse actively participate in a workplace retirement plan, your contributions are deductible no matter what your income is.

A traditional IRA can be useful for those who don’t qualify for a Roth IRA (see next section), for those who anticipate being in a lower tax bracket after retirement and for those who want to save outside their 401(k). It makes sense to invest enough in your 401(k) to get the full matching contribution from your employer, if they offer one. Beyond that, IRAs may offer more investment flexibility than many 401(k)s, though you should learn the details of your 401(k) to be sure. Anyone with earned income who will not reach age 70½ by the end of the calendar year is eligible to open a traditional IRA. If you withdraw funds from your traditional IRA before age 59½, however, you generally have to pay income tax on any pre-tax contributions and earnings, and an additional 10 percent tax on your withdrawal—though some exceptions may apply.

What are Roth IRAs?

Roth IRAs are attractive accounts for those who can afford to pay taxes now for the reward of federally tax-free income later (state taxes may apply). Since contributions to Roth IRAs aren’t tax-deductible, you pay more in income taxes up front than you would with a deductible contribution to a traditional IRA. The trade-off is when you withdraw your contributions, you get to take home the full amount federal tax-free (as long as at least five years have passed since your first Roth IRA contribution and you’re older than 59½). In addition, unlike deductible contributions to traditional IRAs, contributions to a Roth IRA can be withdrawn at any time, tax- and penalty-free, although taxes and penalties may apply to the portion of the withdrawal representing earnings.

Two other features set the Roth IRA apart from the traditional IRA: There is no age limit to open a Roth IRA and no required minimum distributions once you reach age 70½. However, to contribute for 2018, you must have earned income, and single tax filers must make less than $135,000 per year, while joint tax filers must make less than $199,000 per year. The IRS adjusts these limits annually.

You may contribute to both a traditional and a Roth IRA, though there is an annual contribution limit—for 2018, the maximum combined limit across both accounts is $5,500 (or $6,500 if you will be age 50 or older at any time during the calendar year).

What are IRAs for the self-employed?

A simplified employee pension (SEP) IRA can be a good option for those who are self-employed. That includes about 15 million Americans, according to 2016 data from the U.S. Department of Labor. SEP IRAs allow you to set aside up to 20 percent of your self-employment income, up to $55,000 through 2018, though some exceptions may apply.

SEP IRAs work like traditional IRAs, which means you don’t pay taxes on your contributions and earnings until you withdraw them in retirement. There is no Roth option for SEP IRAs.

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2018 IRA comparison

Source: IRS, 2018

Traditional IRA
Income limits: None
Annual contribution limits: $5,500 under age 50, $6,500 age 50 and over
Tax breaks: Contributions may be tax-deductible, depending on your income and if you or your spouse actively participates in a workplace retirement plan
Taxes on withdrawals: Taxed as income
Earliest distribution age: 59 and a half; without penalty, subject to exceptions
Required distribution age: 70 and a half
Penalties: Withdrawals before age 59 and a half are subject to income tax and an additional 10% tax; exceptions may apply

Roth IRA
Income limits: $135,000 single, $199,000 married
Annual contribution limits: $5,500 under age 50, $6,500 age 50 and over
Tax breaks: Contributions are not tax-deductible
Taxes on withdrawals: Federal tax-free (state and local taxes may apply)
Earliest distribution age: Any time (excluding earnings); without penalty, subject to exceptions
Required distribution age: None
Penalties: Withdrawals of earnings before age 59 and a half are subject to income tax and an additional 10% tax; exceptions may apply

SEP IRA
Income limits: None
Annual contribution limits: 20% of net earnings up to $55,000; exceptions may apply
Tax breaks: Contributions are tax-deductible
Taxes on withdrawals: Taxed as income
Earliest distribution age: 59 and a half; without penalty, subject to exceptions
Required distribution age: 70 and a half
Penalties: Withdrawals before age 59 and a half are subject to income tax and an additional 10% tax; exceptions may apply

What are savings IRAs vs. investment IRAs?

Once you determine your account type, you may be able to choose between an investment IRA and a savings IRA. Think about your retirement goals, your financial health and your life stage to help you determine which kind of IRA would be better for you. Savings IRAs are offered by banks and feature FDIC-insured CDs and money market savings accounts. These are lower-risk accounts that offer the potential for relatively stable, modest yearly returns, often without any annual or custodial fees.

Investment IRAs are offered by investment firms and may allow you to invest in stocks, bonds, exchange-traded funds (ETFs) and mutual funds. These accounts may make sense for those who are willing to accept some risk in their retirement accounts in exchange for the potential for greater long-term growth. Investment IRAs are not FDIC-insured, are not bank guaranteed and have the potential to lose value.

No matter which kind of IRA you choose, saving or investing for retirement should be at the top of your list of financial priorities. With retirements lasting longer than they used to, the sooner you start preparing, the better off you could be.

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The material provided on this website is for informational use only and is not intended for financial or investment advice. Bank of America and/or its affiliates, and Khan Academy, assume no liability for any loss or damage resulting from one’s reliance on the material provided. Please also note that such material is not updated regularly and that some of the information may not therefore be current. Consult with your own financial professional when making decisions regarding your financial or investment options.

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