An individual retirement account lets you save money for retirement and get tax breaks for doing so.
What is an Individual Retirement Account (IRA)?
An individual retirement account (IRA) is a tax-advantaged investment account that individuals can use for retirement savings. There are several types of IRAs, such as traditional, Roth, SEP or SIMPLE. Contributions to some IRAs may be tax-deductible or withdrawals may be tax-free.
Why invest in an IRA? A workplace retirement plan such as a 401(k) or pension may not provide you with enough income in retirement. Putting money in an IRA can help you be better prepared for retirement, plus it can help you save on taxes and get access to investment options that your workplace retirement plan might not offer. In an IRA, your savings may grow faster than in a taxable account.
Understanding Individual Retirement Accounts
How does an IRA work? Here are the key characteristics of IRAs.
You can open an IRA at a bank, robo-advisor or a broker. If you open an IRA at a broker or robo-advisor, you’ll be able to invest in stocks and bonds; IRAs from banks generally offer certificates of deposit and savings accounts.
You invest the money in the account. You can invest in stocks, bonds and other assets. How your account balance grows over time depends on how you invest and how much you contribute to the IRA. (See how to invest your IRA for simple investment strategies.)
IRAs have annual contribution limits. Generally, you (or your spouse) must have earned income to contribute to an IRA.
There are withdrawal rules. You may face a 10% penalty and a tax bill if you withdraw money before age 59 1/2, unless you qualify for an exception. (Note: COVID-19 relief efforts changed the rules for retirement distributions in 2020. Get the details here.)
Here’s an overview of four popular types of IRAs: traditional, Roth, SEP and SIMPLE.
Contributions to traditional IRAs are often tax-deductible. For example, contributing $6,000 to a traditional IRA could reduce the amount of your taxable income by $6,000. However, withdrawals from traditional IRAs in retirement are taxable as ordinary income. The contribution limit for traditional IRAs in 2020 and 2021 is $6,000 per year. People 50 and older can contribute up to $7,000 per year.
If you or your spouse has a retirement plan at work, the amount of your traditional IRA contribution that you can deduct is reduced, or eliminated altogether, once you hit a certain income. You can still make contributions, but they won’t be tax-deductible. If you, and your spouse if you’re married, don’t have retirement plans at work, then you can deduct your IRA contribution no matter how much your income.
Traditional IRA deduction limits in 2020 and 2021
How much of your traditional IRA contributions can you deduct on your taxes? These income limits apply only if you (or your spouse) have a retirement plan at work.
Generally, you can take distributions from a traditional IRA starting at age 59 1/2. If you take money out before then, you may have to pay a 10% penalty (there are some exceptions). You must start taking required minimum distributions when you reach age 70 1/2 or 72, depending on your birthday.
Contributions to Roth IRAs are not tax-deductible, but withdrawals from Roth IRAs are tax-free and there are no taxes on investment gains. Roth IRAs do not have RMDs. Also, you can contribute to a Roth IRA at any age as long as you have earned income. However, there are income limits on who can contribute to a Roth IRA.
In 2020 the contribution limit is $6,000 ($7,000 if 50 or older) for modified adjusted gross incomes below $139,000 (single filers) or $206,000 (married filing jointly). In 2021 the contribution limit is $6,000 ($7,000 if 50 or older) for modified adjusted gross incomes below $140,000 (single filers) or $208,000 (married filing jointly).
Do you qualify for a Roth?
Generally, SEP IRAs are IRAs for self-employed people or small-business owners with few or no employees. Similar to traditional IRAs, the contributions are tax-deductible. Investments grow tax-deferred until retirement, when distributions are taxed as income.
In 2020, contributions are limited to 25% of compensation or $57,000 in 2020, whichever is less. In 2021, the limit rises to $58,000. There’s no catch-up contribution at age 50+ for SEP IRAs, and SEP IRAs require minimum distributions beginning at age 72. SEP IRAs require proportional contributions for each eligible employee if business owners contribute for themselves.
SIMPLE IRAs (Savings Incentive Match Plan for Employees Individual Retirement Accounts) are for small businesses with fewer than 100 employees. Similar to traditional IRAs, the contributions are tax-deductible. Investments grow tax-deferred until retirement, when distributions are taxed as income. Employee contribution limits for a SIMPLE IRA in 2020 and 2021 are $13,500 per year for those under age 50. People age 50 and older can make an additional $3,000 catch-up contribution. Employer contributions are mandatory.
Two popular ways to get an IRA are through brokers and robo-advisors.
Brokers: If you want to choose investments for yourself, an online broker can be a good way to go. Review our best IRA accounts to compare.
Robo-advisors: If you want help managing your retirement account, consider a robo-advisor — a service that selects low-cost and risk-appropriate investments for you. See our list of best robo-advisors for help choosing the right one for you.
See our guide to opening an IRA for more information on moving money into your account.
Here’s how to move your retirement savings to another account. Learn more.
Information for spouses and non-spousal beneficiaries. Learn more.
When you can take withdrawals from your IRA, how much and the potential tax implications. Learn more.
You might qualify for a tax credit of up to $1,000 for contributing to your IRA. Learn more.
Spouses who don’t work for compensation can still contribute to IRAs. Learn more.
Self-directed IRAs (SDIRAs) can hold a variety of alternative investments. Learn more.
A backdoor Roth IRA offers a way to contribute to a Roth IRA even if your income is over the limit for Roth IRA contributions. Learn more.