Individual Retirement Accounts (IRAs) are a popular way to save for retirement. These accounts allow individuals to invest their money and earn returns, helping them grow their savings over time.

IRAs come in different types, including traditional, Roth, and SEP IRAs. Each type has unique rules and benefits, but all IRAs share a common goal: to provide individuals with a way to save for their future and enjoy a comfortable retirement.

What is an individual retirement account (IRA)?

An individual retirement account (IRA) is a long-term savings account that offers tax advantages. Like a 401(k) account, an IRA is designed to persuade people to save for retirement. However, unlike a 401(k), anyone who has earned income can open an IRA and enjoy the tax benefits (reminder: a 401(k) account is only offered through employers and cannot be obtained by an individual. Learn more about 401(k)s. You can open an IRA account through most banks, credit unions, investment companies, online brokerages, or personal brokers. 

Anyone with earned income can open and contribute to an IRA, including people with a 401(k) plan through an employer.

Types of IRAs

There are several types of IRAs, each differing on rules regarding eligibility, taxation, and withdrawals.

Traditional IRA

Like a corporate-sponsored Traditional 401(k), Traditional IRA contributions are made with pre-tax dollars, meaning you get a tax break upfront. However, because of this setup, you get taxed upon withdrawing your money from the account at the current tax rate. In other words, you benefit now (by using pre-tax income) and get taxed later (when you withdraw your money). 

For 2024, annual individual contributions to traditional IRAs can’t exceed $7,000 if you’re under 50. If you’re 50 or older, you can contribute up to $8,000 per year. 

Your traditional IRA contributions are tax-deductible if your employer doesn’t offer a retirement plan. But if you (or your spouse, if you’re married) have a retirement plan through work, such as a 401(k), your modified adjusted gross income (MAGI) determines whether and how much of your traditional IRA contributions can be deducted.

Roth IRA

Like a Roth 401(k), Roth IRAs are accounts you contribute to with post-tax income, but you can withdraw tax-free when you retire. In other words, you get taxed now (by using post-tax income) and get the benefit later (when you pull your money out at retirement tax-free). But unlike a Roth 401(k), anyone with an income can contribute. 

The 2024 tax year Roth IRA contribution limits are the same as those for traditional IRAs. However, unlike traditional IRAs, there are income limitations for contributions to Roth IRAs. 

With traditional IRAs, you get a tax break now and pay taxes later. With Roth IRAs, you pay taxes now and get a tax break later.

SEP IRA

A Simplified Employee Pension (SEP) IRA allows self-employed individuals, like contractors, freelancers, and small-business owners, to set aside money in retirement accounts for themselves and their employees. A SEP does not have the start-up and operating costs of a conventional retirement plan and allows for a contribution of up to 25% of compensation or $69,000 for 2024, whichever is less, of each employee’s pay. 

Business owners who set up SEP IRAs for their employees can deduct their contributions on behalf of employees. However, employees cannot contribute to their accounts, and the IRS taxes their withdrawals as income. 

SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is also meant for small businesses and self-employed individuals. It is best suited as a start-up retirement plan for small employers not sponsoring a retirement plan. Unlike SEP IRAs, SIMPLE IRAs allow employees to contribute to their accounts, and the employer must also make contributions. All contributions are tax-deductible. 

The SIMPLE IRA employee contribution limit in 2024 is $16,000 for individuals under 50, and the catch-up contribution limit is an additional $3,500 for individuals older than 50. 

How does my IRA account earn money?

When you open an IRA, you can invest in various financial products, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds. Some self-directed IRAs (SDIRAs) permit investors to make all the decisions and give them access to a broader selection of investments, including real estate and commodities. Only the riskiest investments are off-limits. 

Whenever your account investments earn interest or a dividend, that amount is added to your account balance. How much your account earns depends on the investments you select and the time you have until withdrawing your earnings. 

Withdrawing from your IRA account

Like a 401(k) account, if you withdraw before 59 ½, you will incur a 10% penalty tax and any taxes on the withdrawal. Additionally, there are some exceptions to this penalty for certain hardships, but the general rule is to wait until retirement before taking distributions. 

Required minimum distributions 

Required Minimum Distributions (RMDs) are minimum amounts you must withdraw annually from your IRA accounts. RMDs act as safeguards against people using retirement accounts to avoid paying taxes. You must begin withdrawing from most retirement accounts by April 1, the year after the account holder reaches 72. From there, the account holder must withdraw the RMD amount each year after that based on the current RMD calculation. The IRS has a worksheet to help determine how much must be withdrawn.  

RMDs are required for Traditional IRAs, SEP IRAs, and SIMPLE IRAs. However, RMDs are not required for Roth IRAs in the account holder’s lifetime. In other words, with a Roth IRA, you can leave your savings in your account for as long as you live. You can also keep contributing to it indefinitely as long as you earn an income and your MAGI doesn’t exceed the annual limits for making contributions. 

Should I have both a 401(k) and an IRA?

If possible, an IRA shouldn’t be your only retirement savings account. If you can access a 401(k) plan through your employer, consider maxing out your 401(k) contribution first. Here’s why:

• If your employer matches contributions, you automatically get a 100% return on part of your investment.

• Your taxes are deferred on a 401(k), so your money grows faster.

• You receive a tax deduction for the year when you contribute, which lowers your current taxes.

Consider funding your 401(k) first to ensure you receive the full match from your employer, then work on maximizing your Roth account. If you have any funds left, you can focus on rounding out your 401(k). 

The bottom line

Saving for retirement is one of the most important things you can do to ensure your financial freedom in the future. An IRA account allows you to save more than your employer-sponsored plan, and it may offer more investment options. It is also a good option if your employer doesn’t offer a retirement savings vehicle.