You can use an individual retirement account (IRA) as a savings account to save for the future while receiving tax benefits. To be eligible for an IRA, you must have earned income. The IRA is designed primarily for self-employed people who do not have access to workplace retirement accounts such as the 401(k), which is available only through employers.
How Does an IRA Work?
Individuals with earned income, even if they already have a 401(k) account through their employer, are eligible to open and make contributions to an IRA. The only restriction is the maximum amount you can contribute to your retirement accounts within one year.
If you decide to open an IRA, you will have the option to invest your money in various financial products such as stocks, bonds, exchange-traded funds (ETFs), and mutual funds.
Investors can make all investment decisions, if they choose, with self-directed IRAs, also known as SDIRAs. SDIRAs provide more investment options, such as real estate and commodities.
Different types of IRAs are available such as traditional IRAs, Roth IRAs, Simplified Employee Pension (SEP) IRAs, and Savings Incentive Match Plan for Employees (SIMPLE) IRAs. There are different rules for eligibility, taxation, and withdrawals for each one.
As an individual taxpayer, you have the option to set up either traditional or Roth IRAs. SEP and SIMPLE IRAs are available for self-employed individuals and small business owners to establish. To open an IRA, you need to choose an institution that has been approved by the Internal Revenue Service (IRS) to offer these accounts. You have various options such as banks, brokerage companies, federally insured credit unions, and savings and loan associations.
If you withdraw money from an IRA before reaching age 59½, there is typically a 10% penalty since the account is intended for retirement savings. Exceptions exist regarding withdrawals, including those for educational expenses or first-time home purchases, among others.
If you withdraw early from a traditional IRA account (not a Roth account), you will be required to pay income tax. When you withdraw money from a Roth account, you won't have to pay additional taxes because the account was funded with post-tax money.
What Are the Different Types of IRAs and Their Rules?
Here is an explanation of the different types of IRAs and their corresponding regulations.
Contributions made to traditional IRAs are usually eligible for a tax deduction. If you contribute $6,000 to an IRA, that amount will be deducted from your annual taxable income.
When you save money in a traditional IRA, it will not be taxed until you withdraw it during retirement. At that time, it will be taxed based on your regular income tax rate for that year.
Contribution Limits for 2023
In 2023, the highest amount an individual can contribute annually is $6,500. If you are age 50 or above, you can make an extra catch-up contribution of $1,000.
Your traditional IRA contributions can be fully deducted if you don't have a retirement plan through your work. If you or your spouse (if you're married) have a workplace retirement plan, like a 401(k) or 403(b), your ability to deduct traditional IRA contributions depends on your modified adjusted gross income (MAGI).
If You Have a Retirement Plan at Work
In 2023, if you are single or the head of household and have a retirement plan at work, you can fully deduct your traditional IRA contributions if your MAGI is less than $73,000.
In 2023, if you are married and filing taxes jointly, you can deduct your traditional IRA contributions completely if your MAGI does not exceed $116,000. As your MAGI increases, the deductibility of your contributions begins to decrease.
In 2023, if you are a married couple and your income falls between $116,000 and $136,000, you will not be able to deduct traditional IRA contributions. Single taxpayers or heads of households with an income between $73,000 and $83,000 are subject to the phase-out range.
If You Don't Have a Plan at Work but Your Spouse Does
In 2023, if you are married to someone who has a workplace plan but you do not, and you contribute to an IRA, your income phase-out range is between $218,000 and $228,000.
You cannot deduct Roth IRA contributions from your taxes for the year in which you make them. However, any distributions you make later on will not be subject to taxes. This means that when you contribute money to a Roth IRA, you use money that has already been taxed and you are not required to pay taxes on the money you earn through investments in the future.
Additionally, it's worth noting that Roth IRAs are not subject to required minimum distributions (RMDs). If you do not require the money, it is not necessary for you to withdraw it from your account. No matter how old you are, as long as you have eligible earned income, you can contribute to a Roth IRA.
The contribution limits for Roth IRAs in the 2023 tax year are identical to those for traditional IRAs. There is a limitation on the amount of income one can have to qualify for contributing to a Roth IRA.
In 2023, if you are a single filer, the range of income where the phase-out applies is $138,000 to $153,000. If you are married and filing joint taxes, the range is $218,000 to $228,000.
SEP IRAs can be established by self-employed individuals including small-business owners, contractors, and freelancers who are often millennials.
Withdrawals from a SEP IRA follow the same tax regulations as withdrawals from a traditional IRA. In 2023, the maximum contribution limit for SEP IRA is 25% of your compensation or $66,000, whichever is lower.
If business owners establish SEP IRAs for their employees, they can deduct the contributions made on behalf of the employees. They are not permitted to add money to their accounts and any withdrawals they make are subject to income tax by the IRS.
The SIMPLE IRA is designed for individuals who are self-employed or own small businesses. Withdrawals from this IRA type are subject to the same tax rules as with a traditional IRA.
SIMPLE IRAs differ from SEP IRAs in that employees can contribute to their accounts, while employers are obligated to contribute as well. The contributions made are eligible for the tax deduction, which can possibly move the business or employee to a lower income tax bracket.
In 2023, the employee contribution limit for SIMPLE IRA is $15,500. Workers who are age 50 or above can make an additional catch-up contribution of up to $3,500.
What Are Required Minimum Distributions (RMDs)?
Owners of traditional IRA and 401(k) accounts must make annual withdrawals called Required Minimum Distributions (RMDs) once they reach a specific age. The age has increased multiple times. Starting from January 1, 2023, account holders are required to withdraw money in the year when they attain the age of 73. This age will increase to 75 in the year 2033.
The IRS provides a worksheet to calculate the required withdrawal amount, which depends on the account size and the person's life expectancy. If you do not withdraw the minimum required amount, you will face a significant tax penalty.
This penalty, which is 25% of the account balance, will be in effect by 2023. The penalty has been reduced by 50%, but it is still sufficiently high to make us stay aware. In many cases, taxpayers can reduce this penalty to 10% by taking corrective action early. Consult your financial planning professional.
What Are the Advantages of an Individual Retirement Account (IRA)?
Saving for retirement is a good idea, and an individual retirement account (IRA) can be a helpful tool. With an IRA, you can receive tax benefits while saving for your future. An IRA has the potential to lower your tax bill either during the contribution phase or when you withdraw funds in retirement, depending on the type of IRA you have. Depending on whether you have a traditional or Roth IRA, investment gains are either not taxed right away (traditional IRA) or not taxed at all (Roth IRA).
Contributing money towards your retirement can result in a reduction of your income taxes for the year or can eliminate the taxes on your retirement funds.
The Federal Deposit Insurance Corp. (FDIC), a government agency, provides insurance for IRAs in case a financial institution fails. FDIC-insured banks or savings and loan associations provide protection to customer deposits up to $250,000 per account in most cases, covered by the FDIC.
How Can I Start a Roth IRA or a Traditional IRA?
Most banks, credit unions, online brokers, and other financial services providers allow you to open an IRA.
When Can I Withdraw From an IRA?
It is best to withdraw from an IRA at age 60 or later.
If you take out your money before reaching the age of 59½, you will face a 10% penalty for early withdrawal, along with taxes on the amount withdrawn. The penalty for not following a rule can be waived in certain cases such as medical expenses, disabilities, first-time home purchases, and other exceptional life circumstances.
In general, if you delay taking distributions, it will allow your money more time to grow.
How Is a 401(k) Plan Different From an IRA?
401(k) plans and IRAs are both beneficial for employees who want to invest for retirement due to their tax advantages.
You can only access a 401(k) plan if it is provided by your employer. The employee's contributions are deducted from their paycheck automatically. Certain companies offer to match a portion of the contributions made by their employees.
401(k) plans allow individuals to contribute more money than they can with an IRA. However, having a 401(k) plan at work is not a requirement for setting up an IRA – anyone who earns income can do so.
401(k) plans typically provide a narrow selection of mutual funds and ETFs, while an IRA can offer a broader array of options namely various funds, stocks, and securities.
The Bottom Line
Retirement savings accounts called IRAs provide tax advantages. They function similarly to a 401(k) plan, but they are not dependent on the sponsorship of an employer. There are several types of IRAs: traditional IRAs, Roth, SEP, and SIMPLE.
Investing in an IRA has limits on the amount of tax you can avoid due to annual income restrictions on deducting contributions to traditional IRAs and contributing to Roth IRAs.
The purpose of IRAs is to save money for retirement over an extended period of time. Withdrawing money from your retirement account before the designated time will reduce the value of your assets, and this contradicts the purpose of saving for retirement. Typically, if you withdraw money from an IRA before reaching age 59½, you may be subject to a tax penalty of 10% on top of the regular taxes owed. This is why it's not recommended to withdraw from an IRA before this age.
About William Bevins, CFP®
William Bevins is a CERTIFIED FINANCIAL PLANNER™ and wealth advisor serving Middle Tennessee. His practice focuses on writing financial plans, wealth management, offering advice, and building suitable investment portfolios for individuals, small to medium-sized businesses, and family offices. He may be contacted by email at [email protected].