An individual retirement account (IRA) is an excellent way to save for retirement, even if you have access to an employer-sponsored retirement plan. These accounts come with tax advantages that can help you make the most of your retirement savings plan.
Despite their benefits, only about 18% of working-age Americans have an IRA, according to a recent survey by the U.S. Census Bureau.
Because IRAs come with some limitations and restrictions, it's critical to understand how they work and whether they're a good fit for you. Here's everything you need to know.
What is an IRA?
An IRA is a tax-advantaged investment account designed for retirement savings. Depending on the type of individual retirement account you choose, your portfolio can grow on a tax-deferred or tax-free basis, and you may be able to deduct your contributions.
Once you open the IRA, you can invest your funds in a variety of financial securities, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and more.
In retirement, you can withdraw from the IRA to help supplement other savings and income.
Like other tax-advantaged investment accounts, however, there are plenty of rules, restrictions, and limitations that could impact your ability to earn tax breaks. (More on those in a minute.)
Types of IRAs
There are a handful of different types of individual retirement accounts from which you can choose. The right one for you may depend on your income, your needs, and your tax preferences.
Traditional IRA
A traditional IRA is a tax-advantaged investment account that allows you to save for retirement on a tax-deferred basis.
Contributions can be tax-deductible in the year you make them if you meet certain criteria. However, when you take withdrawals in retirement, both your contributions and your earnings will be taxed as income.
You may consider this option if you expect your tax bracket in retirement to be lower.
Roth IRA
A Roth IRA allows you to make contributions with after-tax money, which you can't deduct on your tax return. However, funds will have the potential to grow on a tax-free basis, and you can withdraw them tax-free in retirement as long as the account owner is at least 59 1/2 years old and the account has been opened for at least five years.
While individual retirement accounts typically penalize early withdrawals before you reach age 59½, Roth IRAs allow you to withdraw your contributions at any time without incurring taxes or penalties. You may also be able to withdraw earnings tax- and penalty-free if you meet certain requirements, as noted above.
You may consider this option if you believe you'll be in a higher tax bracket in retirement.
SEP IRA
A simplified employee pension IRA, or SEP IRA, is a type of traditional IRA designed for small businesses and self-employed individuals. This type of IRA only allows contributions from the employer, but employees can open a separate IRA for their own contributions. SEP IRA contributions from your employer won't affect your personal contribution limits.
Roth IRA vs Traditional IRA
Both Roth and traditional IRAs can be an excellent way to invest for retirement. The differences between them can help you determine which one is the better fit for you:
Feature | Roth IRA | Traditional IRA |
Contributions | After-tax dollars | Pretax or after-tax dollars |
Deductible contributions | No | Yes, if you meet certain criteria |
Annual contribution limits for 2023 | $6,500 ($7,500 if you're age 50 and over) | $6,500 ($7,500 if you're age 50 and over) |
Earnings growth | Tax-free* | Tax-deferred |
Tax on withdrawals | No taxes on contributions; no taxes on earnings when withdrawn after five years, after age 59½, or if you meet certain other requirements | All withdrawals taxed as ordinary income |
Withdrawal penalties | 10% penalty on early withdrawals; no penalties when withdrawing contributions and no penalties when withdrawing earnings after five years and after age 59½ | 10% penalty on early withdrawals; no penalties when withdrawing after age 59½ |
Eligibility | Taxpayers with earned income below a certain threshold | Any taxpayer with earned income |
Required minimum distributions (RMDs) | In 2023, no RMDs until after the owner dies; in 2024 and beyond, no RMDs | Must start taking RMDs after age 73 (72 if you reached that age prior to Dec. 31, 2022) |
*If certain conditions met
IRA vs 401(k)
Unlike traditional and Roth individual retirement accounts, 401(k) plans must be offered through an employer. Depending on what your employer offers, you may be able to choose a traditional or Roth 401(k) plan, each of which comes with similar features as traditional and Roth IRAs, respectively.
The good news is that you can utilize both a 401(k) and an IRA to make the most of your retirement savings. However, if you're trying to decide between the two, here's how they differ:
Feature | IRA | 401(k) |
Contributions | Pretax or after-tax dollars | Pretax or after-tax dollars |
Deductible contributions | Varies | No; traditional 401(k) contributions are automatically excluded from your income |
Annual contribution limits for 2023 | $6,500 ($7,500 if you're age 50 and over) | $22,500 ($30,000 if you're age 50 and over) |
Earnings growth | Tax-free or tax-deferred | Tax-free or tax-deferred |
Tax on withdrawals | Varies | Varies |
Withdrawal penalties | Varies | Varies |
Eligibility | Taxpayers with earned income (must be below a certain threshold for Roth) | Employees of employers that offer a sponsored plan |
Required minimum distributions (RMDs) | Varies | Must start taking minimum withdrawals after age 73 (72 if you reached that age prior to Dec. 31, 2022) |
How does an IRA work?
Individual retirement accounts can vary in some of their eligible criteria, terms, and limitations, so it's important to know how they work and whether you're eligible.
IRA contribution limits
In 2023, the annual contribution limit for individual retirement accounts is $6,500. If you're at least 50 years old, you can add an extra $1,000 per year in catch-up contributions. The contribution limits apply to all of your IRAs, not each individual account.
Roth IRA income limits
The IRS limits who can contribute to a Roth IRA based on modified adjusted gross income (MAGI) and filing status. Once your income exceeds a certain threshold, your annual contribution limit will be phased out until it reaches zero:
Filing status | Income limit for making maximum contributions | Ineligible for contributions |
Married filing jointly or qualifying widow(er) | $218,000 or less | $228,000 or more |
Married filing separately, and you lived with your spouse at any time during the year | $10,000 or less | $10,000 or more |
Single, head of household, and married filing separately, but you didn't live with your spouse during the year | $138,000 or less | $153,000 or more |
Traditional IRAs are open to anyone who has earned income. However, the amount of your contributions you can deduct varies, depending on your MAGI and whether you have an employer-sponsored retirement plan.
Like Roth IRAs, traditional IRAs allow a full deduction up to a certain threshold, a partial deduction during a phase-out period, and no deduction after a certain level.
Covered by a retirement plan at work | ||
Filing status | Income limit for taking the full deduction | Ineligible for deduction |
Married filing jointly or qualifying widow(er) | $116,000 or less | $136,000 or more |
Married filing separately | Less than $10,000* | $10,000 or more |
Single or head of household | $73,000 or less | $83,000 or more |
*If you're married and filing separate tax returns, you cannot take a full deduction. Income below $10,000 is eligible only for a partial deduction.
Not covered by a retirement plan at work | ||
Filing status | Income limit for taking the full deduction | Ineligible for deduction |
Married filing jointly with a spouse who is covered by a work plan | $218,000 or less | $228,000 or more |
Married filing jointly or separately with a spouse who is not covered by a work plan | No limit | No limit |
Married filing separately with a spouse who is covered by a work plan | Less than $10,000* | $10,000 or more |
Single, head of household, or qualifying widow(er) | No limit | No limit |
*If you're married and filing separate tax returns and your spouse is covered by a work plan, you cannot take a full deduction. Income below $10,000 is eligible only for a partial deduction.
Taxes
With a traditional IRA, withdrawals made in retirement will be taxed based on your ordinary income tax rate. However, Roth IRA distributions are not taxed when made in retirement.
Required minimum distributions (RMDs)
When you have a traditional IRA, you must take required minimum distributions (RMDs) when you reach the age of 73 (or 72 if you reached that age before Dec. 31, 2022). Your RMD is calculated based on your age and life expectancy.
Roth IRAs don't require minimum distributions until after the death of the owner.
Withdrawals
If you take distributions from your IRA before you reach age 59½, you may be subject to income taxes and a 10% penalty on the withdrawal. However, the penalty may be waived if you use the funds for certain purposes.
Roth IRAs come with special rules that can help you avoid taxes and penalties. For starters, you can withdraw up to the amount you've contributed to the account without incurring taxes or penalties. Additionally, you can withdraw earnings in a Roth IRA starting five years after your first contribution with no taxes or penalties as long as you are at least age 59 1/2.
4 benefits of investing in an IRA
Regardless of which type of IRA you choose, there are many benefits to using one to plan for retirement:
Save on taxes: Whether you opt for tax-free potential growth with a Roth IRA or tax-deferred potential growth and deductions with a traditional IRA, you can enjoy significant tax savings with an individual retirement account.
More control: With a 401(k) plan, your investment options and fees are determined by your plan provider. With an IRA, you can shop around and compare providers based on fees and investment options to find the right fit for you.
No employer requirement: You don't need your employer to set up an individual retirement account for you. What's more, you can open an IRA even if you have an employer-sponsored retirement plan.
Some flexibility with early withdrawals: While there are some limitations on when you can withdraw money from your retirement account, there is some flexibility with certain reasons. If you opt for a Roth IRA, you'll have even more flexibility.
How to open an IRA
You can open an IRA with any bank or broker that offers them, including Acorns Later. The process of opening an IRA can vary slightly depending on the provider. But in general, here's what to expect.
Step 1: Decide which type of IRA you want
Based on taxation and withdrawal rules, think about your current financial situation and your goals to determine whether a traditional or Roth IRA is right for you. Due to income limits, you may decide to start with a Roth IRA, then switch to a traditional IRA at a later date.
Step 2: Compare your options
In addition to comparing individual retirement account providers, you'll also want to consider whether you want to manage your investment portfolio on your own through an online broker or you want assistance via a robo-advisor or human advisor.
Investing on your own can give you more control, but handing off the reins to an advisor can save you some time and help you avoid making emotional decisions about your portfolio. Robo-advisors are typically less expensive than human advisors and often include benefits like portfolio rebalancing.
Step 3: Open an account
Once you've settled on which type of IRA you want and a provider, start the application process with the provider. You'll typically need to give basic details about yourself, including your name, address, date of birth, Social Security number, contact information, and employment details.
You may also need to provide some documentation to prove your identity.
Step 4: Fund your account
Your IRA provider will give you instructions on how to fund your account, typically via a bank transfer, IRA balance transfer, an account with another firm, or from a 401(k) rollover.
Once your account is funded, you can open your portfolio and set up regular contributions going forward.
This material has been presented for informational and educational purposes only. The views expressed in the articles above are generalized and may not be appropriate for all investors. The information contained in this article should not be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. There is no guarantee that past performance will recur or result in a positive outcome. Carefully consider your financial situation, including investment objective, time horizon, risk tolerance, and fees prior to making any investment decisions. No level of diversification or asset allocation can ensure profits or guarantee against losses. Article contributors are not affiliated with Acorns Advisers, LLC. and do not provide investment advice to Acorns’ clients. Acorns is not engaged in rendering tax, legal or accounting advice. Please consult a qualified professional for this type of service.
