IRA Basics

Individual retirement accounts (IRAs) are a popular type of retirement savings account you can invest in to save for your retirement. 

What is an IRA?

An IRA, or individual retirement account, is a personal savings plan that offers a variety of tax benefits. 

Eligibility

Whether you’re already participating in an employer-sponsored retirement plan and would like to save more, or you don’t currently have access to an employer plan, an IRA may provide you with options to help save for retirement.

  • There are no age limits for eligibility, but you or your spouse must earn income (up to a certain limit) to contribute to an IRA.
  • Depending on your income level and the type of IRA you choose, you can hold a wide range of investments and take advantage of several tax benefits.

Types of IRAs accounts

Four types of IRAs to consider are: 

  • Traditional IRAs
  • Roth IRAs
  • Simplified Employee Pension (SEP) IRA
  • Savings Incentive Match Plan for Employees (SIMPLE) IRAs 

Traditional IRA

If you have an earned income or are a non-working spouse of a person with an earned income, you can contribute to a traditional IRA. The age limit for contributions for the 2020 tax year or later was removed by the SECURE Act.

The contribution limit for 2021 is $6,000 for individuals up to age 50 or $7,000 if you are age 50 or older. You can contribute the maximum contribution limit if your taxable compensation (or your spouse’s compensation) for the year is at least that amount. If taxable compensation is below the contribution limit, you can only contribute up to the amount earned.  Your deductible contribution can also be limited by IRS imposed income phase outs.

Required minimum distributions 

It is also important to note that federal law requires you to withdraw a minimum amount from a traditional IRA each year once you reach age 72. If you take a distribution prior to age 59 ½, without meeting one of various exceptions, the amount will be subject to a 10% IRS penalty.

Deductible traditional IRA contributions can be more advantageous if you expect to be in a lower tax bracket when you retire.

Roth IRA

Unlike traditional IRAs, Roth IRAs have income limits for eligibility. Even if you meet the requirements to set up a Roth IRA, you may not qualify to take full advantage of its benefits. Here are the main requirements:

  • You or your spouse must have taxable compensation.
  • If taxable compensation is at least $6,000, you may be able to contribute that full amount.
  • Your ability to contribute to a Roth IRA depends on your modified adjusted gross income (MAGI) and income tax filing status. If you are:
    • Single or head of household: You can make a full $6,000 ($7,000 if you are 50 or older), contribution to your Roth IRA if you have an MAGI of $125,000 or less. Your Roth IRA contribution limit is reduced if your MAGI is more than $125,000 and less than $140,000, and you cannot contribute to a Roth IRA at all if your MAGI is $140,000 or more.
    • Married, filing jointly or qualifying widow(er): You can make a full contribution to your Roth IRA if your MAGI is less than $198,000. Your Roth IRA contribution limit is reduced if your MAGI is more than $198,000 and less than $208,000, and you cannot contribute to a Roth IRA at all if your MAGI is $208,000 or more.
    • Married filing separately: Your Roth IRA contribution is reduced if your MAGI is less than $10,000, and you can't contribute to a Roth IRA at all if your MAGI is $10,000 or more.

You might consider a Roth IRA if you are in a lower tax bracket now and anticipate being in a higher tax bracket during retirement.

SEP vs. SIMPLE IRA

SEPs and SIMPLEs are employer sponsored plans, so you need to either be a business owner or work for an employer who is sponsoring a plan to be able to participate.
 

  SEP SIMPLE IRA
What is it? Simplified employee pension Savings Incentive Match Plan for Employees
What kind of employer offers this plan? For-profit, nonprofit or government organizations For-profit, nonprofit or government organizations with fewer than 100 employees
Who is eligible?

Employees who:

  • Are aged 21 or older.
  • Have worked for the business in at least 3 of the last 5 years.
  • Have received at least $650 in compensation in the current year.
An employer can choose to have less restrictive eligibility requirements

Employees who:

  • Earned at least $5,000 of compensation in any 2 previous years of service.
  • Anticipate earning at least $5,000 in the current year.
An employer can choose to have less restrictive eligibility requirements
2021 contribution limits Your employer can contribute 25% of your salary to a SEP, up to $58,000.*

You can contribute up to $13,500* if you are under age 50.

If you are age 50 or older, you can contribute $16,500.*
 

Considerations

All eligible employees automatically benefit.

You cannot make contributions from your salary, as a SEP is an employer-funded plan.

You must select beneficiaries and choose the investments.

Immediate vesting.

Employer contributions are discretionary.

No option for Roth contributions.

No option for Roth contributions.

 

Additional employer contributions are required, as it is an employer-sponsored plan.

 

There is a 25% penalty on early withdrawals (prior to age 59 1/2) for the first 2 years of your participating in the SIMPLE IRA Plan and a 10% penalty thereafter.
*Based on 2021 limits

Understanding the types of retirement accounts can help you financially prepare to reach your retirement goals.

IRAs and taxes

Traditional IRA tax considerations

For traditional IRAs, your contributions may be tax deductible on your federal income tax return, which can lower your taxable income for the year and save you money.

If neither you nor your spouse are covered by a 401(k) plan or another employer-sponsored plan, you can usually deduct the full amount of your annual IRA contribution. However, if you or your spouse is covered by a retirement plan at work, your ability to deduct your contributions depends on your modified adjusted gross income (MAGI) and your income tax filing status.

Roth IRA tax considerations

Roth IRA contributions are not tax deductible. Only after-tax dollars can be invested in a Roth IRA. However, if you meet certain conditions, your withdrawals from a Roth IRA will be income tax free, which includes contributions and investment earnings. Generally, you are eligible for these distributions if:

  • You meet a five-year holding period requirement
  • You reach age 59 ½ by the time of the withdrawal
  • You make the withdrawal due to disability
  • You make the withdrawal to pay first-time home-buying expenses (lifetime limit is $10,000)
  • Your beneficiary or estate makes the withdrawal after your death

If you meet the qualifications, you can also avoid the 10% early withdrawal penalty. Note that nonqualified distributions will be taxed (and can even be penalized) only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions that you have made. Ensure you aggregate your Roth IRAs when calculating the tax consequences of a distribution.

Another benefit of Roth IRAs is that there are no required distributions after age 72 or at any time during your life. You can put off taking distributions until you need the income, or you can leave the balance to your beneficiary without taking a distribution. Owners of Inherited Roth IRAs are required to take distributions. 

IRA vs. 401(k): Key differences

Unlike traditional and Roth IRAs that do not have age limits, you typically must be at least 21 years old to contribute to a 401(k) plan, with at least 1 year of service with your company. However, you can contribute more to your 401(k) — the maximum employee contribution is $19,500 for those under age 50 and $26,000 if you are age 50 or older for 2021.

Additionally, if your 401(k) plan permits, you may be eligible to make after-tax contributions. These contributions do not count toward the $19,500 maximum but do count against the $58,000 limit (or $65,000 if 50 or older) for 2021. This contribution limit also includes any employer matching or profit-sharing contributions.

Note that, similar to a traditional IRA, there is a 10% IRS penalty on early withdrawals. But 401(k) plans have an exception to the penalty if you leave your employer in the year you turn 55 or older that doesn’t exist on IRAs.

Pros and cons of IRAs and 401(k) plans

  401(k) IRA
Pros

Some employers may match employee contributions to a 401(k) plan.


401(k) contributions generally do not have income limits (some highly compensated employees may have their contribution amounts reduced)

IRAs typically have more investment choices than a 401(k).


You can take a withdrawal from your IRA account at any time (taxes and penalties may apply) contributions would reduce your taxable income for the year.

Cons

401(k) plan participants are limited to the plan’s available investment options.


You generally can’t take a withdrawal from a 401(k) plan unless you leave your employer (or qualify for a hardship distribution). 

Traditional and Roth IRAs do not offer matching contributions from an employer.


Traditional IRAs have income limits for deductibility (if you or your spouse have a plan at work). Roth IRAs have income limits for contributions.

 

Rollover evaluator

If you have multiple retirement savings accounts held in more than one place, the rollover evaluator will help you understand the pros and cons of keeping your retirement savings in an employer-sponsored plan such as a 401(k) or 403(b) versus rolling it over into an IRA.

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