Article

IRAs: Your Complete Guide

Regular savings accounts are fine for storing short-term savings, but if you’re saving for retirement, an Individual Retirement Account (IRA) is better.

Dayana YochimMay 30, 2019

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What is an IRA?

An Individual Retirement Account (IRA) is an investment account designed for building retirement savings, apart from a workplace 401(k). There are several types — traditional IRAs, Roth IRAs, SEP IRAs, SIMPLE IRAs — but all offer tax benefits that reward you for saving.

What are the benefits of an IRA?

  • Both of the primary varieties of IRAs — the traditional IRA and the Roth IRA — allow you to save $6,000 per year ($7,000 if you’re 50 or older), even if you’re also contributing to a 401(k) or other workplace savings plan. (Note: Those limits are up from $5,500 and $6,500 in 2018.)

  • With a traditional IRA, contributions are tax-deductible up to IRS limits, and you won’t owe income taxes until you withdraw the funds. With a Roth IRA, contributions are not tax-deductible, but unlike with a traditional IRA, your investments grow tax-free and you can withdraw money tax-free in retirement from a Roth.

  • Both traditional IRA and Roth IRA accounts are available from online brokers and from banks, but the types of investments you’ll have access to within your IRA will vary depending on the provider. With a bank IRA, you’ll likely find savings-type vehicles, such as certificates of deposit. With a broker, you’ll be able to invest in stocks and bonds, which offer much higher average returns. (Don’t worry if you’re new to this realm. See how to invest your IRA for some simple investment tips.)

  • There are other types of IRAs, with a variety of benefits in different situations. For example, SEP IRAs can help self-employed people ramp up their retirement savings, while spousal IRAs are ideal for married couples where one spouse doesn’t work for pay. Read on for more details on a variety of IRA types.

How to choose the right IRA

First things first: Not everyone is eligible for all the perks of traditional and Roth IRAs.

Your income level will determine whether you’re allowed to contribute to a Roth IRA. Anyone — regardless of income — can contribute to a traditional IRA. But the amount of your traditional IRA contribution that you can deduct from your taxes may be limited by your income if you or your spouse has access to a retirement plan at work.

In addition to eligibility rules, here are some considerations to help you decide between them:

Traditional IRA

With a traditional IRA, generally you can deduct the amount of your contributions on your tax return, and your money grows tax-deferred — that is, you won’t owe income taxes until you withdraw the money from your account. But if you (or your spouse) has a retirement plan at work, then check out the deduction limits:

If you’re eager to get a tax break today versus one in retirement, a traditional IRA may be a good choice. What’s the advantage? Perhaps you’re subject to a high tax bracket today and expect to be in a lower tax rate in retirement. Or maybe the upfront tax break is what attracted you to IRAs in the first place.

Keep in mind that to avoid a withdrawal penalty when taking money out of a traditional IRA, you'll need to be age 59 ½ or meet some specific requirements — see traditional IRA withdrawals for details.

Roth IRA

If you’ve got the willpower to wait to get your tax break, the Roth can be an especially attractive option. With a Roth IRA, contributions are not tax-deductible, but your money grows tax-free — you never owe taxes on the investment gains in your account — and you can withdraw money tax-free in retirement.

While you can’t deduct Roth contributions from your taxable income while you’re saving, in retirement your Roth withdrawals are not taxed at all. That goes for contributions and investment earnings. (With a traditional IRA, you pay taxes on both your contributions and earnings when you withdraw money.)

The Roth comes with another big perk: You can take out money you contributed to a Roth IRA at any time without penalty. But there are rules about early withdrawals of investment earnings and other transferred funds — see Roth IRA withdrawals for details.

There are income limits that prevent higher earners from contributing to Roths. (However, in that situation, a backdoor Roth IRA is another option — more on that below). Here are the latest Roth IRA contribution limits:

Other types of IRAs

While traditional and Roth IRAs are the primary varieties, there are other types of IRAs that might be a better fit for your situation.

If your income priced you out of making Roth IRA contributions, fear not. You can still open a Roth, thanks to the backdoor Roth IRA option. (The name “backdoor Roth” is not an official account name; it describes a tax strategy.)

Put simply, you open a traditional IRA and then convert it to a Roth. Ideally, your traditional IRA accounts — the one you want to convert other traditional IRAs you might have — consist entirely of nondeductible contributions. If not, be prepared for a tax bill. The IRS’s pro-rata rule means that if you have traditional IRA contributions for which you’ve taken a tax deduction, even if those contributions are in another traditional IRA account, some portion of the money you convert to the Roth IRA likely will be taxable. Read more about backdoor Roth IRAs.

Generally, to contribute to an IRA, you need to have earned income. A spousal IRA is one exception to that rule: these accounts let spouses who don’t work for pay contribute to an IRA, either a traditional IRA or a Roth IRA, based on their working spouse’s income.

The spousal IRA is owned by the non-working spouse, and the maximum contribution is $6,000 ($7,000 if 50 or older). But there’s another limit: the total contributions of both spouses to each of their IRAs can’t exceed the working spouse’s earned income. Read more about spousal IRAs.

Technically, almost all IRAs are self-directed, in that you choose your own investments for the account. But “self-directed IRA” has come to describe a special type of IRA: one that lets you invest in alternative investments in your IRA, such as real estate or a privately-held company. You’ll need to find an IRA custodian who’s willing to let you do that — the brokers that are household names generally don’t offer self-directed IRAs.

Self-directed IRAs can come in the traditional or Roth flavor, and they have the same income and eligibility rules. The only difference is the type of investments you own in the account. Read more about self-directed IRAs.

SEP stands for “simplified employee pension.” These IRAs are a useful retirement savings tool for small-business owners and self-employed people. Like a traditional IRA, a SEP IRA offers a tax deduction on contributions. Your savings grow tax-deferred, and withdrawals in retirement are taxed at regular income tax rates.

If you have eligible employees, the IRS requires you to contribute to their accounts at the same rate that you contribute to your account. For example, if you’re saving 10% of your compensation, then you must contribute the same percentage of employees’ compensation to their accounts. Employees generally can’t contribute to a SEP IRA (though some SEP IRAs allow for traditional IRA contributions).

The big appeal of these accounts for business owners is that the maximum contribution is $56,000 in 2019, much higher than the $6,000 max for traditional IRAs. One caveat: You can’t contribute more than 25% of compensation. Read more about SEP IRAs.

SIMPLE IRAs are retirement savings vehicles for small companies, generally with 100 or fewer employees. Compared with a 401(k), a SIMPLE IRA is relatively easy for employers to set up. (SIMPLE stands for Savings Incentive Match Plan for Employees.)

Employers are required to contribute to the plan, based on specific IRS rules. And, unlike a SEP IRA, with a SIMPLE IRA employees can contribute their own money, up to $13,000 a year, an extra $3,000 catch-up contribution for people 50 and older. The amount employees contribute will reduce their taxable income for the year, and their money will grow tax-deferred until they withdraw it in retirement, at which point income taxes apply on withdrawals. Read more about SIMPLE IRAs.

An inherited IRA, also known as a beneficiary IRA, comes with some very specific rules — and you want to follow them so you avoid a big tax bill. Keep in mind that the rules vary depending on your relationship with the deceased person. Read more about inherited IRAs.

Opening your IRA

Before choosing an IRA provider, ask yourself how involved you want to be in the management of your investments:

  • If you want to choose investments for yourself, an online brokerage is a good way to go. Review our best IRA accounts to compare.

  • 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.

Once you have chosen a provider, the online signup process for an IRA is pretty simple: You'll be asked to provide some general information, including Social Security number, birthdate, information and employment details. See our guide to opening an IRA for more information on moving money into your account.

IRA FAQs

It’s undoubtedly a good investment vehicle, but it’s not technically an investment in and of itself: An IRA is a type of account that holds your investments, just like a bank account is a holding pen for your cash. The amount of money you earn in an IRA is based on the investments held in the account.

While you can certainly hold cash in your IRA, the purpose of the account is to achieve better investment returns than you’d get by placing that money into a savings account at your bank.

If you have a decade or more until you retire, we recommend allocating a significant portion of your IRA to stocks. Specifically, we’re talking about investment vehicles like mutual funds and exchange-traded funds (ETFs) that provide exposure to the stock market. The stock market’s average return has historically been far higher than what you’d earn with bonds, a certificate of deposit or even a high-yield savings account.

Here’s a four-step plan for choosing investments for your IRA.

Thank you for asking and allowing us to clear up a common misconception: An IRA is not technically an investment. It’s merely an account, albeit a special tax-sheltered account, that enables savers to hold whatever investments you choose — hence, those choices will impact your IRA’s performance more so than the place you go to open it.

That said, there is merit in asking where the best place is to open an IRA. You can whittle down the universe of dozens of potential IRA providers based on how involved you want to be in managing your account:

If you want to choose and manage your investments, you’ll need an online broker. An online brokerage account allows you to buy and sell investments you choose and manage your retirement portfolio on your own.

When we evaluate brokers, we’re looking for ones that charge low or no account fees, and reasonable commissions; offer a wide selection of no-transaction-fee mutual funds and commission-free exchange-traded funds; and provide solid customer support and educational resources. You also want to make sure that the broker offers the investments you need. You can buy most stocks at any broker, but their mutual fund lineups can vary, and not all brokers carry funds from all providers.

If you’d like an automated way to manage your investments, consider a robo-advisor. A robo-advisor chooses low-cost mutual funds and ETFs (exchange-traded funds) that align with your investing preferences and timeline. Their services cost a fraction of what a human financial manager typically charges.

When shopping for a robo-advisor you want to look for one with a low management fee — generally 0.40% or less — and services that meet your needs (such as access to human financial advisors or banking services). Automatic rebalancing and portfolio allocation are standard offerings with most robo-advisors.

» MORE: See which discount brokers and robo-advisors are standouts in our list of the best IRA accounts.

Both IRAs and 401(k)s are retirement savings accounts, and both offer tax breaks as an incentive to sock away money for your future. But 401(k)s are available only through an employer (in technical IRS language, they're employer-sponsored retirement plans) while an IRA can be set up by any individual who has earned income.

Other noteworthy differences:

- 401(k)s have higher annual contribution limits than IRAs: $19,000 in 2019 versus $6,000 in an IRA. - Catch-up contribution limits are also beefier in workplace plans: If you’re age 50 or older, the IRS allows you to save an additional $6,000 every year in a 401(k). The maximum annual catch-up contribution allowed in an IRA is $1,000. - You have until the tax filing deadline in April of the following year to make contributions to an IRA. Contributions to a 401(k) must be made by Dec. 31 in order to qualify for the current tax year. - Some 401(k)s have a vesting period where employees have to wait a certain period of time before they’re allowed to participate in the plan. There’s no vesting period with an IRA. - Some employers sweeten the pot with 401(k)s and kick in their own money to match a portion of what employees save. That extra money may be subject to a vesting period. - Investment offerings in a 401(k) are determined by the plan administrator. In an IRA the choices are much broader: If you choose to open an account at a discount brokerage you can pick from mutual funds, exchange-traded funds (ETFs), stocks and more.

If you’re wondering if it’s better to have a 401(k) or an IRA, here’s some good news: You don’t have to choose. The IRS allows savers to contribute to both an IRA and a 401(k) at the same time. And if you leave your company, you can take the money with you and roll it over into an IRA. (Here’s how to do a rollover IRA.)

Our advice: If your 401(k) offers an employer match, invest enough to get the full match. After that, direct your retirement savings dollars into a Roth or traditional IRA to take advantage of the more expansive line-up of investments.

Here’s a more detailed take on the IRA vs. 401(k) question, including a simple plan for how to maximize your returns and minimize your costs.

Once you’ve set up your account — deposited money and indicated which type of IRA you want — it’s time to select investments. If you do nothing, your money will sit in cash. However, as we said earlier, cash isn’t an ideal investment when saving for a long-term goal like retirement.

If you set up an IRA at a discount broker, you have an array of investment options, including individual stocks, bonds and mutual funds. Simply indicate what you want to purchase and the broker will facilitate the trade as long as you’ve deposited enough money in the account to cover the cost of any commission the price of a single share of a stock or ETF. If you’re purchasing a mutual fund, you’ll need an account balance that can meet the minimum investment requirement for a mutual fund as well as any commission. (See more on how to invest in mutual funds.)

Before your money is invested by a robo-advisor, you’ll be asked to complete a brief questionnaire about your investing goals, time frame (when you'll need the money) and your tolerance for risk. The robo-advisor will make investment recommendations — a mix of mutual funds and exchange-traded funds (ETFs) — based on your answers. You’ll be given the opportunity to review the recommendations and then the money will be invested accordingly.

Here’s more on how to invest your IRA.

It is possible, depending on what you invest your IRA money in. If you’re investing in the stock market, there will be times your account balance may dip when the market does what it’s historically done over short periods of time: seesaw between highs and lows. But don’t let that spook you.

Over the long term — which is the investing time horizon you have in your IRA — investing in the stock market gives you the biggest bang for your buck. From a historical standpoint, an investment in an index mutual fund that tracks the returns of 500 of the largest U.S. companies is likely to far outpace what you’d earn investing in Treasury bonds, T-bills or even gold.

The key to ensuring any losses are just temporary is to stay the course. Having a long-term investing time horizon and the temperament to weather the storm are how fortunes are made. Fidelity Investments studied the behavior of about 1.5 million people in workplace retirement plans. It found that investors who continued to invest in stocks even through the 2008-09 market crash ended up 10 years later with account balances about 50% higher than people who sold out of stocks during the downturn.

Yes, but not always without consequences. Ideally, you should let that money marinate in the account until you’re at least age 59 ½. Any earlier and you may trigger a hefty income tax bill as well as a 10% early withdrawal penalty.

That said, if you absolutely must access the money before then, Roth IRA early withdrawal rules are a lot more lenient than the penalties for prematurely dipping into a traditional IRA.

You can tap into your Roth IRA contributions at any time and for any reason without paying any taxes or penalties. That’s because a Roth is funded with after-tax dollars and the IRS already got its cut. Roth IRA earnings are another matter: Early distributions of investment earnings before the account is at least five years old will be accompanied by taxes and penalties, with a few exceptions. (Read more on Roth IRA early withdrawal rules.)

Early withdrawals from a traditional IRA — again, before age 59 ½ — will likely be taxed and penalized 10%. Some exceptions to the 10% penalty are using IRA money to pay for higher-education expenses, a first home purchase (limited to a $10,000 withdrawal), and unreimbursed medical expenses that exceed 7.5% of your adjusted gross income. (Read more on traditional IRA early withdrawal rules.)

Contributions to a traditional IRA can immediately reduce your taxable income dollar-for-dollar up to the contribution maximum ($6,000 in 2019). That means if you earned $50,000 and maxed out an IRA, you’d only owe income taxes for the year on $44,000. But please note: Your deduction may be reduced if you or your spouse have access to a retirement plan at work, depending on your income. (See the IRA deduction limits in the table in the article above.) Since the IRS gave you an upfront deduction, distributions in retirement will be taxed at your then income tax rate.

Contributions to a Roth IRA are made with after-tax dollars, so funding one won’t provide an immediate tax break. It’s when you start taking distributions in retirement that you’ll get tax relief: You won’t owe the IRS anything on qualified withdrawals.

Investment growth within both Roth and traditional IRAs is either tax-free or tax-deferred. With a Roth IRA, it’s tax-free, meaning you’ll never owe taxes on that money. With a traditional IRA, it’s tax-deferred, meaning you’ll owe taxes only when you start withdrawing the money in retirement.

In the short term, you have until the tax filing deadline in April to make contributions to a Roth or traditional IRA for the previous year.

Over the long term, the IRS restricts your ability to make traditional IRA contributions starting with the year you turn 70 ½. There is no age limit on Roth IRA contributions.

Many discount brokers and robo-advisors have $0 minimums to open an IRA. You can see which ones in our roundup of best IRA providers. However, the tax perks of investing in an IRA start only when you start contributing money to the account. But don’t worry: You don’t need to come up with your full contribution all at once. You’re also not required to save the maximum the IRS allows (up to $6,000 in 2019, or $7,000 if you’re age 50 or over).

You can add money to your IRA at whatever cadence and amount work for your budget. Many brokers and robos allow savers to set up automatic deposits to transfer money from your bank into your account.