Individual Retirement Account (IRA)

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What Is an Individual Retirement Account (IRA)?

An individual retirement account (IRA) is a tax-advantaged account that individuals use to save and invest for retirement. There are several types of IRAs—Traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. Each has different rules regarding eligibility, taxation, and withdrawals. https://96dfb20e901e7fba26343086f8e5c771.safeframe.googlesyndication.com/safeframe/1-0-37/html/container.html

Key Takeaways

  • IRAs are tax-advantaged accounts that individuals use to save and invest for retirement.
  • Types of IRAs include traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.
  • If you withdraw money from an IRA before age 59½, you are usually subject to an early-withdrawal penalty of 10%.
  • There are income limitations for contributing to Roth IRAs and deducting contributions to traditional IRAs.
  • Rules regarding maximum contributions and income limits for IRAs change each year.

Understanding Individual Retirement Accounts (IRAs)

So how does an IRA work? Investments held in IRAs can encompass a range of financial products, including stocks, bonds, ETFs, and mutual funds. A self-directed IRA can be a traditional IRA or a Roth IRA. Self-directed IRAs allow investors to make all the decisions and give them access to a broader selection of investments, including real estate, private placements, and commodities.1

Individual taxpayers can establish either traditional and Roth IRAs, while small-business owners and self-employed individuals set up SEP and SIMPLE IRAs. An IRA must be opened with an institution that has received Internal Revenue Service (IRS) approval to offer these accounts. Choices include banks, brokerage companies, federally insured credit unions, and savings and loan associations. Most individual investors open IRAs with brokers.1 https://96dfb20e901e7fba26343086f8e5c771.safeframe.googlesyndication.com/safeframe/1-0-37/html/container.html

Your income and whether you have a retirement plan at work influence which types of IRAs you can open and whether your contributions will be tax-deductible.2 Because IRAs are meant for retirement savings, there is usually an early withdrawal penalty of 10% if you take money out before age 59½. Depending on what type of IRA you have, you may also need to pay income tax on your early withdrawal.3

You can only contribute to an IRA with earned income that meets IRA rules. Income from interest and dividends, Social Security benefits, or child support does not count as earned income.45 2:11

Roth IRA Vs. Traditional IRA

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Types of Individual Retirement Accounts (IRAs)

The following is a breakdown of the different types of IRAs and the rules regarding each.

Traditional IRA

In most cases, contributions to traditional IRAs are tax-deductible. If someone puts $6,000 into an IRA, that person’s taxable income decreases by the amount of the contribution. However, when that individual withdraws money from the account during retirement, those withdrawals are taxed at their ordinary income tax rate. For 2021, annual individual contributions to traditional IRAs cannot exceed $6,000 in most cases. If you are 50 or older, you can contribute up to $7,000 per year using catch-up contributions.6

For 2021, the IRS changed the income phaseout range for deducting contributions to a traditional IRA for investors with retirement plans at work. The phaseout range changed from $104,000–$124,000 in 2020 to $105,000–$125,000 for married couples and from $65,000–$75,000 to $66,000–$76,000 for singles.6

Several key factors determine if you can deduct your traditional IRA contributions. Suppose that you are a single person or file as head of household and have a retirement plan, such as a 401(k) or 403(b), available at work. Your traditional IRA contributions are fully deductible if your modified adjusted gross income (MAGI) was $65,000 or less in 2020. In 2021 the limit is $66,000. If you’re married filing jointly, the limit is $104,000 or less in 2020 and $105,000 in 2021. If you earn more, you begin to lose deductions.6 Use this chart to figure out where you fit.

Deduction Limits If You Have a Retirement Plan at Work
Filing Status2020 MAGI2021 MAGIDeduction
Single or Head of Household   
 Less than $65,000Less than $66,000Full deduction up to your contribution level
 More than $65,000 but less than $75,000More than $66,000 but less than $76,000Partial deduction
 $75,000 or more$76,000 or moreNo deduction
Married Filing Jointly   
 Less than $104,00Less than $105,000Full deduction up to your contribution level
 More than $104,000 but less than $124,000More than $105,000 but less than $125,000Partial deduction
 $124,000 or more$125,000 or moreNo deduction
Married Filing Separately   
 Less than $10,000Less than $10,000Partial deduction
 $10,000 or more$10,000 or moreNo deduction

Starting at age 72, holders of traditional IRAs must begin taking required minimum distributions RMDs), which are based on their account size and life expectancy. Failure to do so may result in a tax penalty equal to 50% of the amount of the required distribution.

In 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act increased the age requirement of taking RMDs from 70½ to 72. It also eliminated the age limit of when a person can contribute to an IRA, which was 70½. A person of any age with earned income can now contribute to an IRA.7

Typically, taxpayers have until the April 15 tax filing deadline to make an IRA contribution for the prior tax year. For example, you have until April 15, 2021, to contribute to an IRA for the 2020 tax year.

Roth IRA

Roth IRA contributions are not tax-deductible, but qualified distributions are tax-free. You contribute to a Roth IRA using after-tax dollars, but you do not face any taxes on investment gains. When you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roth IRAs also do not have RMDs. If you don’t need the money, you don’t have to take it out of your account. You can still contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.8

Roth IRA contribution limits for 2020 and 2021 are the same as for traditional IRAs. However, there is a catch. There are income limitations for contributing to a Roth IRA.9 The phase-out range for single filers is between $124,000 to $139,000 in 2020 and between $125,000 to $140,000 in 2021. For married couples filing joint taxes, the phase-out range begins ranges between $106,000 to $196,000 in 2020 and $108,000 to $198,000 in 2021.6

Income Limits for Contributing to a Roth IRA
Filing Status2020 MAGI2021 MAGIContributions
Single or Head of Household   
 Less than $124,000Less than $125,000Up to the limit
 $124,000 to less than $139,000$125,000 to less than $140,000Reduced amount
 $139,000 or more$140,000 or moreZero
Married Filing Jointly or Qualifying Widow(er)   
 Less than $196,000Less than $198,000Up to the limit
 $196,000 to less than $206,000$198,000 to less than $208,000Reduced amount
 $206,000 or more$208,000 or moreZero
Married Filing Separately   
 Less than $10,000Less than $10,000Reduced amount
 $10,000 or more$10,000 or moreZero

SEP IRA

Self-employed individuals, such as independent contractors, freelancers, and small-business owners, can set up SEP IRAs. The acronym SEP stands for “simplified employee pension.” A SEP IRA adheres to the same taxation rules for withdrawals as a traditional IRA. For 2021, SEP IRA contributions are limited to 25% of compensation or $58,000, whichever is less. 6

Business owners who set up SEP IRAs for their employees can deduct the contributions they make on behalf of employees. However, company employees are not allowed to contribute to their accounts, and the IRS taxes their withdrawals as income.10

SIMPLE IRA

The SIMPLE IRA is also intended for small businesses and self-employed individuals. The acronym SIMPLE stands for “savings incentive match plan for employees.” This type of IRA follows the same tax rules for withdrawals as a traditional IRA. 11

Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions as well. All the contributions are tax-deductible, potentially pushing the business or employee into a lower tax bracket.12 The SIMPLE IRA employee contribution limit in 2021 is $13,500, and the catch-up limit (for those workers age 50 and older) is $3,000, the same as 2020. 6

In 2008, the IRS issued “Revenue Ruling 2008-5,” which says that IRA transactions can also trigger the wash-sale rule. Should shares be sold in a non-retirement account, followed by substantially identical shares being purchased in an IRA within a 30 day period, the investor cannot claim tax losses for the sale. The investment’s basis in the individual’s IRA won’t be increased either.13

Comparing IRA Options

Use the chart below to get a better sense of how the different IRAs work.

Note: To see the full chart, use the slider at the bottom to see the column at the far right.

Comparing IRA Types
 IRA Type Employee
​Contribution Limit (2021)
 Tax-Deductible Contributions? Tax-Free Distributions? Subject to Required Minimum Distributions Beginning at Age 72? Who Can Establish
 Traditional $6,000; $7,000 if age 50 or older Yes, but individual deduction amounts are based on income, filing status, and retirement plan coverage through your employer No Yes Individual taxpayers and couples*
 Roth$6,000; $7,000 if age 50 or older No Yes No Individual taxpayers and couples*, subject to MAGI limitations
 SEP The lesser of 25% of compensation or $58,000 Business deductions for employee contributions are limited to the lesser of your total contributions or 25% of employees’ compensation Self-employed individuals must use a special formula to calculate the amount of contributions they can deduct No Yes Small business owners and self-employed individuals
 SIMPLE $13,500; $16,500 if age 50 or older All contributions made to employees’ SIMPLE IRAs by the plan owner are tax deductible Self-employed individuals can also deduct contributions made to their own SIMPLE IRA No Yes Small business owners and self-employed individuals

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