IRAs (Individual Retirement Accounts) are certainly popular. According to research from the Investment Company Institute (ICI), about 55.5 million US households owned these accounts. There are a few reasons why so many investors favor IRAs, but chief among them is that an IRA provides valuable tax benefits, which can boost your nest egg. ICC estimates that – for those who have held their IRAs for at least ten years – the average balance is $280,000.
It's important to understand how to use these powerful savings tools. And you will need to decide which type is best for you: traditional, Roth, SEP or SIMPLE?
What is an IRA?
An IRA is not an investment. Rather, an IRA is an account that holds investments, such as stocks, bonds, mutual funds and ETFs (exchange-traded funds). Some accounts even allow investing in real estate, though the IRS prohibits certain types of assets like collectibles.
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“For those without access to a retirement savings plan through their employer, an IRA is the perfect way to benefit from tax-advantaged savings that would otherwise be inaccessible,” said Michelle Riiska, who is a ChfC and planning consultant at eMoney Advisor, the second largest wealth management platform in the US.
There are two types of IRAs for individuals: traditional IRAs and Roth IRAs. There are also plans available for those who are self-employed or own small businesses.
How an IRA works
For traditional IRAs and Roth IRAs, the contribution limit for 2024 and 2025 is $7,000. If you are 50 or older, you can make a “catch-up” contribution of $1,000. You can make contributions for the current year by the tax filing deadline of the following year, which is typically April 15th.
But you can only make contributions with earned income. Earned income includes wages, salaries, tips, bonuses, commissions and net earnings self-employment income. But it does not include items like interest, capital gains, rental income, dividends, pensions, unemployment compensation and annuities.
There is an exception if you have a non-working spouse and file jointly. For example, suppose you have earned income of $60,000 and your spouse has no income. You can set up an IRA for $7,000 for yourself and a separate, spousal IRA of $7,000 for your partner. However, if your income was lower than the combined contribution of $14,000, then you can only allocate the amount up to your annual income.
Once you've settled on an IRA, your next decision will be whether to get a Roth IRA or a Traditional IRA.
Traditional IRA
If you or your spouse do not have an employer retirement account — like a 401(k) plan — you can make tax-deductible contributions to a traditional IRA. Otherwise, the deduction is phased out based on your income. But you can still make nondeductible contributions.
On the earnings of your IRA, the taxes are deferred until you make withdrawals. If you do not do this before reaching age 59 ½, you will pay income taxes on the amount and a 10% penalty. But there are exceptions, such as:
- Total and permanent disability
- Health insurance premiums while unemployed
- Unreimbursed medical expenses
- Expenses for higher education
- First-time home purchases up to $10,000
Let’s take an example of how the taxes work with a traditional IRA. You have an annual income of $80,000 and make a $7,000 contribution. This lowers your taxable income to $73,000, which means you get a $1,540 tax savings (22% of $7,000). For the year, the capital gains and dividends are $400, which is not taxable. This gives you an additional savings of $88.
A traditional IRA is subject to required minimum distributions (RMDs), meaning you need to withdraw a small percentage of the account each year. Owners of traditional IRA accounts must start taking RMDs when they reach age 72 (73 if you are age 72 after Dec. 31, 2022). Due to the SECURE 2.0 Act, the RMD age will rise again to 75 in 2033. This RMD rule applies even if you are retired. If you do not make the distributions when required, the penalty is 25%.
Roth IRA
You cannot deduct your contributions to your Roth IRA, but the taxes on the earnings in the account are deferred until they are withdrawn.
So, what’s the advantage of a Roth IRA? You can take out the contributions in your account tax-free without penalty. As for the earnings, they are also tax-free if you make the withdrawals when you are 59 ½ or older and have held the Roth IRA for at least five years.
However, there are restrictions on your contributions. The amount is phased out based on your modified adjusted gross income (MAGI). For example, if you are single or file jointly, then the phaseout period begins at $146,000 and $230,000 for 2024. For 2025, the phaseout begins at $150,000 and $236,000 respectively. If you are bumping up against those income levels, you can still qualify for Roth IRA contributions by lowering your income. Several strategies, like contributing to a Health Savings Account (HSA), can lower your MAGI and set you up for a more secure retirement.
A Roth IRA can be beneficial if you expect to be in a higher tax bracket. But there are other benefits. For example, there are no RMDs and you can pass your account tax-free to your heirs.
“The choice of contributing to a traditional IRA and Roth IRA is not all or nothing,” said Rob Williams, managing director of financial planning at Charles Schwab. “We suggest that investors consider contributing to both, dividing the amount half and half, or in a proportion that meets your current needs, budget, and preference for more flexibility and less tax for when you reach retirement.”
Spousal IRA
Spousal IRAs not only give a nonworking spouse a measure of retirement security, but the contributions allow the couple to save more for retirement on a tax-advantaged basis and reduce tax liability.
If one spouse has earned income and the couple files a joint tax return, the working spouse can contribute to an IRA in the non-working spouse’s name. Spousal IRAs are an ideal way for spouses who plan to take time out of the workforce to continue to save for retirement.
The total contribution to a spousal IRA can’t exceed the taxable income reported on the couple’s joint federal tax return. Regardless of who contributes to the account, the account is owned by the nonworking spouse, and it is theirs to keep, even if the marriage ends in divorce.
Rollovers and conversions
A "rollover" refers to moving funds from one type of retirement account to another, usually tax-free. If you have a 401(k), you may want to roll over the account into an IRA when you leave your job or retire. Some employers allow this type of rollover when you reach 59-½ and remain an employee.
There are key advantages to a rollover compared to cashing out of your 401(k). A rollover allows you to continue to benefit from the tax deferral of the IRA, which will help you build your retirement nest egg.
Your IRA will have many more investment options, and the fees may also be lower.
Keep in mind that there are two types of rollovers:
Direct Rollover: The plan administrator of the 401(k) transfers the amount in the account directly to the IRA. This method is straightforward and avoids potential tax issues.
Indirect Rollover: You receive the funds from your 401(k) and then have 60 days to deposit them into an IRA. Otherwise, the amount will be subject to income taxes and a 10% penalty if you are younger than 59-½. Your employer may also withhold 20% in taxes. While you can reclaim this withheld amount when you file your taxes, it can be a hassle. Due to these issues, it’s usually best to use a direct rollover.
You can also roll over your 401(k) into a Roth IRA. However, the IRS considers this a conversion. That's because the regular 401(k) defers taxes, while a Roth IRA does not. This means you will owe income taxes on the amount of the distribution, which could be significant.
You may also convert a traditional IRA into a Roth IRA.
IRAs for the self-employed and small businesses
SEP IRA. A SEP IRA (Simplified Employee Pension Individual Retirement Account) is for someone who is self-employed or has a small business. The owner is the only one who can make contributions to the account. They will also be required to make contributions for employees who are at least 21 years old, have worked for the business for at least three of the last five years and have received a minimum of $750 income in 2024. Because of this, the owner will usually have a SEP if there are few or no employees.
The main advantage of a SEP IRA is that you can contribute up to 25% of compensation, with a maximum of $70,000. These contributions are tax deductible and the earnings are deferred from taxes. However, there is no catch-up contribution for older workers.
SIMPLE IRA. If your business has employees, a better option is the SIMPLE IRA (Savings Incentive Match Plan for Employees). In fact, this can be a great way to recruit and retain employees. Moreover, when compared to a 401(k), there is generally less paperwork and lower costs.
With this type of account, each employee will have their own account and the contribution limit is $16,500 for 2024 and $16,500 in 2025. If the employee is age 50 or older, then there is a catch-up contribution limit of $3,500 for 2024 and 2025.
Beginning in 2025, there will be an increase in the catch-up contribution limits for participants who have reached ages 60 through 63. The new catch-up contribution limit will increase to the greater of $5,000 or 150% of the regular age 50 catch-up contribution limit for SIMPLE IRA plans in 2025. Those who are 60, 61, 62, or 63 can contribute $5,250 more to SIMPLE plans for 2025.Cost of living adjustments will begin in 2026.
However, an employer is required to make contributions on behalf of employees. This is either a dollar-for-dollar match of up to 3% of compensation or a flat rate of 2% of compensation, which is capped at $350,000.
For both a SEP IRA and a SIMPLE IRA, you will pay taxes on the withdrawals from the account. There is a 10% penalty if this is done before reaching age 59-½. As for a SIMPLE IRA, the penalty is 25% if the withdrawal was completed within two years of participation in the plan.
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