What is IRA?
An IRA is an Individual Retirement Account in the United States. It is a long-standing savings account for retirement that allows an individual to save money on a tax-deferred or tax-free basis, depending on the type of IRA chosen. The tax benefit allows your savings to potentially grow, or compound, more quickly than in a taxable account.
An IRA can also be an alternative that enables small companies to offer retirement plans to their employees.
Note: IRA also stands for Irish Republican Army for the Irish, but this article deals with Individual Retirement Accounts.
How does an IRA work?
- An IRA is better than a savings account because it yields higher interest rates and tax is deferred until distribution/withdrawal.
- An IRA can be used by individuals who are not employed by a company and thus do not have a 401(k) retirement account.
- IRAs are like Individual Savings Accounts (ISP) and Self -Invested Personal Pensions (SIPP) in the UK and Tax-Free Savings Accounts (TFSA) in Canada
- IRAs make money through interest earned on the investments made under the IRA. The interest earned on the investment also earns interest.
- An IRA is the same as a 401(k) plan as both are retirement plans and enjoy tax benefits, but in an IRA, the individual account holder manages the account directly instead of the employer.
- An account holder can have a 401(k) plan and an IRA, provided the account holder can comply with the required contributions of both.
- An IRA is a sound option for a retirement plan because of the tax benefits and having complete control over your investments. You will decide what to invest in, for how long, and how much.
- An IRA can be opened through an investment company, a bank, an online brokerage company, or a personal broker. After opening the IRA, the account holder can make contributions to the IRA.
IRA Rollovers are the transfer of funds from a 401(k) plan to an IRA. A rollover is done to keep the funds in tax-deferred status and to avoid tax penalties for early withdrawals of funds from an IRA account or a 401(k) plan.
Only one IRA rollover can be done in a year, even if the account holder has several IRA accounts.
After an IRA is opened, contributions can be made to grow the account. IRA contributions are funds deposited to the IRA to grow the investment. IRA contributions. can be as cash, check, or a rollover from a 401(k). However, IRAs have a contribution limit.
An account holder can contribute $6,500 per year if below 50 years old and $7500 if above 50. This is effective in 2023, wherein an additional $500 was added to what used to be $6000 for those below 50 and $7000 for those above 50.
It is possible for an account holder to have multiple IRAs but the total maximum IRA contribution remains the same. This means if your total IRA contribution annually is $6500, this amount will be split among the IRA accounts you will be contributing to. You learn more about IRA contribution limits in this IRS link.
IRA Distributions (Withdrawals)
IRA distributions are withdrawals of funds from the account. The rules for withdrawing money from an IRA are as follows:
- 1Since IRAs are long-term savings accounts, you cannot withdraw from them until you reach the age of 59 ½.
- 2You can start taking the money out of an IRA upon reaching 59 ½, wherein withdrawals before retirement will not incur tax penalties
- 3An early withdrawal subjects the amount withdrawn to be part of the gross income, with an additional 10% tax as a penalty. There are exceptions to the 10% tax penalty for early withdrawals if they are for:
- A beneficiary or estate, as a result of the IRA owner’s death
- A permanently disabled account holder
- A portion of equal periodic fund releases for life/life expectancy, or joint lives/joint life expectancies of the account holder and designated beneficiary
- A qualified home purchased for the first time, not exceeding $10,000
- Qualified higher education costs
- An amount not exceeding health insurance premiums after the account holder received unemployment compensation (or eligible unemployment compensation amount if the account holder status is not self-employed)
- An amount not exceeding unreimbursed medical costs more than a certain percentage of account holder's adjusted gross income
- Payment to be made directly to the US Government to abide by an IRS levy of the IRA based on section 6331of the Code
- Qualified reservist distribution
- Exempted from additional income tax by the federal legislation related to some disasters and emergencies
- Amount not exceeding $5000 for a qualified birth or adoption.
- 4Traditional, SEP, SIMPLE, and gold IRA distributions are taxed after retirement because they were in tax-deferred status previously. Roth IRA distributions are not subject to tax when withdrawn beyond age 59 ½ and if the account is beyond five years in existence because Roth IRA contributions are not tax-deferred.
- 5The age for required minimum distributions (RMD) is 73, (raised from 72, as of January 1, 2023). By this age, the IRA account holder must withdraw even just a partial amount from the account.
- 6The first RMD must be April first of the year, following the year an account holder turns 73. Every year henceforth, withdrawals will be scheduled for December 31 yearly. You can learn more about RMDs here.
- 7All RMD withdrawals are taxed as income. Non-withdrawal incurs a 50% excise tax on the amount not withdrawn.
IRAs and Tax Reporting
Account holders must report IRAs on a tax return, especially withdrawals, which are part of the taxable income. One of the tax advantages of an IRA is that IRA contributions are tax-deferred and are thus deducted from the total taxable income. The IRA custodian, a company that facilitates tax documentation for IRAs, is required to report on all IRA transactions an account holder makes in a year.
Types of IRAs
There are five types of IRAs to choose from, depending on the type of investment preferred. Here are the different types of IRA and their benefits:
Tax-deductible contributions, IRA earnings are not taxed. Distributions/ withdrawals will be taxed as income if withdrawn after 59 ½.
- Tax-deferred growth
A Roth IRA Contribution is from after-tax funds and isn’t tax deductible. Roth IRA withdrawals from retirement onwards are tax-free.
- Tax-free distributions
- No age requirements
- Best plan for those in their 20s and 30s to compound tax-free funds for longer periods.
- Withdrawals are penalty-free anytime
- No required minimum distributions
- Unemployed spouse is employed
- Heirs get the money from Roth IRA tax-free
SEP stands for Simplified Employee Pension; a retirement benefit option used by small businesses and self-employed individuals. A SEP IRA is similar in function to a traditional IRA.
- Tax-deferred growth
- A SEP-IRA requires lower start-up/ operational expenses for employers
- Higher annual contribution ceiling
SIMPLE stands for Savings Incentive Match Plan for Employees, a plan similar to 401(k) designed for companies with 100 or fewer employees. A SIMPLE IRA is less complicated, with lower contributions and less expensive administration.
- Tax-deferred growth
- Easier to set up and less expensive to operate
- More investment options
- No years of tenure requirement to own the investment
- With a SIMPLE IRA plan,, the employer gets tax deductions for contributions to employees’ accounts
Precious Metal IRA
- Tax-deferred growth
- A good hedge against inflation
- A good option to diversify a retirement plan
- Growth potential is independent of inflation and stock market developments
Backdoor Roth IRA
Note that a Roth IRA has an income limit. Individuals whose incomes exceed the income limit can no longer contribute to a Roth IRA account. This is where a “backdoor Roth IRA is used.”
A backdoor Roth IRA allows account holders with high incomes to still fund a Roth IRA by putting after-tax money in a traditional IRA and then converting the funds from the traditional IRA to a Roth IRA.
IRAs also involve a certain risk, especially for investments in stocks and EFTs, which can be affected by drastic economic changes, inflation rates, and market volatility. An IRA CD is an option for investors who prefer a less risky investment with a definite outcome.
An IRA CD integrates the stability of a Certificate of Deposit (CD) savings account with an IRA’s tax benefits. This retirement savings option is best for investors who prefer having a stable and predictable income though the returns are more limited.
What is a 401(k) plan and why is it compared to an IRA?
- A 401(k) plan is a retirement account a company opens and pays for with its employees. A 401(k) plan is compared to an IRA because both are retirement accounts.
- 401(k) plans are usually managed by a company’s human resource division/department as part of the benefits that an employee gets from said company.
- The 401(k) plan was first introduced in 1978 and has since become the most popular retirement benefit companies give to their employees.
- A 401(k) plan is funded by payroll deductions and employer contributions. These funds serve as an investment with taxes deferred until the employee withdraws the funds.
- A 401(k) is an employment retirement account, while an IRA is an individual retirement account.
IRA vs. 401(k) Plans
401 (k) Plans
- Traditional IRA
- Roth IRA
- SEP IRA
- SIMPLE IRA
- Gold/ Precious Meal IRA
- Traditional 401 (k)
Opening the Account
Set up by account holder
Set up by the employer
Account holder funds account with cash, check, bank transfer, and rollover from 401 (k) if the account employed
Deducted from employee's payroll, with equal employer contribution
Maximum Annual Contribution
Maximum Catch-up Contribution (aged >50)
Choice of Investment
A variety of assets and investments chosen by the account holder
Starting at age 73 or 75 depending on the account holder’s year of birth.
*Roth IRAs are not subject to RMDs while the account holder is still alive, but will be to beneficiaries of Roth IRA accounts.
Starting at age 73 or 75 depending on the account holder’s year of birth
An IRA is an excellent alternative for individuals who are self-employed, for small companies with less than 100 employees, and for those who want control over their investments. The tax benefits are similar to a 401(k) plan, and the different IRAs serve a good purpose for those who need them.
Choosing which is better between a 401(k) and an IRA really depends on the individual who has to choose. For those employed, having a 401(k) plan takes care of their retirement savings but having an IRA on top of a 401(k) plan is good if the account holder is well-versed in making investments and can fulfill the financial requirements of both investment plans.
For those who are self-employed, the IRA is a good retirement investment if with proper guidance from a financial advisor. For small companies, the SEP and SIMPLE IRA options provide retirement benefits for employees without being too costly and complicated to manage.