Types, Benefits, and Expert Tips for 2024
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- An Individual Retirement Arrangement (IRA) is a type of retirement account for individuals that provides various tax advantages.
- Depending on which type of IRA you have, you contribute either pre- or post-tax dollars and invest the funds.
- IRAs come with more investment flexibility than 401(k)s, which are employer-sponsored plans.
IRAs are some of the best retirement plans for growing your nest egg through compound interest and investment opportunities. An IRA is just one of many retirement account options, and there are several types to choose from. The right choice will depend on your retirement goals, timeline, and expectations for future taxes.
Here’s everything you need to know about opening an IRA, contribution limits, tax advantages, and the best IRA investment strategies in 2024.
What is an IRA account?
Definition and purpose of an IRA
Individual Retirement Arrangements (IRAs) are retirement accounts for individuals to save pre- or after-tax dollars toward their post-working years. Like a 401(k), IRAs have compounding power that can help them grow significantly over time.
“IRAs are simple and are an extremely easy investment plan to help save for your retirement years,” says Wilson Coffman, CFA, the president at Coffman Retirement Group.
IRAs have many tax benefits and can allow you to invest funds in various assets. However, there are age limits on when you can withdraw funds (or face a penalty), and in many cases, the contribution maximums may be lower than on other retirement accounts. For example, 401(k)s allow you to contribute up to $23,000 annually.
You can’t start withdrawing from your IRA until you are at least 59 1/2, or the IRS will charge you a 10% penalty fee. The purpose of this penalty is to discourage the misuse of funds and promote long-term growth for future retirees.
This rule has some expectations, as you won’t be charged the 10% fee if you meet IRS hardship guidelines for a qualified, penalty-free withdrawal.
Opening and funding an IRA account
To open an IRA, you go through a brokerage or local back. “IRAs are extremely easy to establish and set up,” Coffman says. “Most banks offer an IRA, and any broker will offer IRA accounts. There are also many investment firms, like Fidelity, that can offer investment platforms for online retirement savings accounts as well.”
Once set up, you’ll fund the account using bank payments, checks, or an IRA rollover if you have a different retirement account or old 401(k). The best rollover IRAs offer direct rollovers or trustee-to-trustee transfer by contacting your existing plan’s administrator.
You can also take a distribution and deposit it in your new IRA within 60 days.
Types of IRA accounts
Traditional IRA
This type of IRA is funded with pre-tax earnings. Contributions are tax-deductible; you’ll pay taxes on the funds when you withdraw them in retirement. They’re typically best if you expect your retirement tax bracket to be lower.
Roth IRA
With Roth IRAs, you fund the account with after-tax earnings. This allows the money to grow tax-free, and you’ll pay no additional taxes upon withdrawal. They’re a good option if you predict your retirement tax bracket will be higher.
Original Roth IRA contributions (not the growth) can be withdrawn penalty-free at any point before you’re 59 1/2, essentially acting as an emergency fund. That said, you’ll get the most out of your Roth IRA by leaving the funds alone for as long as possible and contributing regularly.
SEP IRA
SEP IRAs are for employees of self-employed professionals or small businesses who are at least 21 years old and have worked for the employer for at least three of the last five years. They have much higher contribution limits than traditional and Roth IRAs and are taxed upon withdrawal.
All contributions from the employer to the SEP-IRA are 100% vested immediately.
SIMPLE IRA
SIMPLE IRAs are another type of small business retirement account for self-employed individuals or businesses with 100 employees or less. Qualifying employees must also have made at least $5,000 in the last two years and expect the same amount in the current year.
Employers must match employee contributions dollar for dollar up to 3% of the employee’s salary. Employee contributions are 100% vested immediately.
Benefits of IRA accounts
Tax advantages
One of the biggest benefits of contributing to an IRA is the tax advantages. Since IRAs can be funded with either pre-tax (traditional IRA) or after-tax (Roth IRA), you can receive one of two tax benefits: tax-deferred growth or tax-free withdrawals.
You deduct your contributions from your current taxes by funding your account with pre-tax dollars. During retirement, you’ll only pay tax on the amount withdrawn, including the growth. This is especially beneficial if you predict you’ll be in a lower tax bracket during retirement and, therefore, pay a lower tax rate on your contributions.
After-tax contributions mean you pay tax now to receive tax-free growth and withdrawals later. You won’t have to worry about moving to a state with a higher tax rate or diminishing potential gains. This tax advantage is best for individuals who predict their tax bracket will be higher during retirement.
Potential for growth and compound interest
In addition to tax advantages, IRAs are known for their powerful wealth-building capabilities. Money in your IRA can be invested in securities like stocks, bonds, ETFs, and mutual funds. IRAs also grow with the magic of compounding.
With compound interest, the interest earned each period (month, year, etc.) gets added to your principal amount. This means the next time interest is calculated, it’s applied to a larger amount, leading to faster growth over time. The longer your money is allowed to compound, the greater the growth potential.
IRA Contribution limits for 2024
The IRS has set contribution limits on IRAs, but the exact amount depends on your age, your taxable compensation for the year, and the type of IRA you’ve established.
Annual contribution limits
The IRS has set contribution limits on IRAs, but the exact amount depends on your age, your taxable compensation for the year, and the type of IRA you’ve established.
Here’s how IRA contributions break down for 2024:
Income limits and eligibility for a Roth IRA 2024
Choosing the right IRA
Factors to consider
Some factors to consider when choosing the right IRA include:
- Investment strategy: Consider the investment strategy you prefer to grow your nest egg. Generally, the best IRA investment strategy for long-term wealth building is a buy-and-hold strategy, which mitigates risk and volatility while utilizing compound interest. However, some pre-retirees (particularly younger traders) may prefer an active, riskier strategy with the potential for higher gains.
- Investment options: What kinds of investable securities do you want to buy and sell in your IRA? IRA companies offer a wide range of investment options, including stocks, bonds, ETFs, and mutual funds. Some providers offer alternative investment options like real-estate, art, and cryptocurrencies.
- Fees and expenses: Ensure you understand all the fees associated with the IRA provider you sign up with. This includes account fees, annual fees, management fees, transaction fees, and expense ratios. Fees can diminish potential returns over time, so it’s important to compare fees between different providers.
- Investment tools and research: Consider the kinds of investment tools, services, and research that can help you make smart investment decisions. These could include educational resources, portfolio analysis tools, tax-loss harvesting, and market research reports.
- Minimum investment requirement: Some online brokerages and apps require a minimum investment to open an IRA and start investing. There are many low-cost IRAs with no minimums and other more robust IRA providers with minimums ranging from $5 to $100. Before signing up, know how much you need to invest to get started.
- IRA match: Some IRA providers now offer an IRA match, similar to a 401(k) employer match. When you contribute to your retirement account, your IRA may contribute a matching contribution up to a certain percentage. However, only a handful of investment platforms offer this perk.
Comparing traditional and Roth IRAs
The most common types of IRAs are traditional and Roth. They act very similarly, providing the same investment options and contribution limits. Most IRA providers typically offer both kinds to anyone with earned income.
Pre-tax dollars fund traditional IRAs, so you only have to pay income tax on the amount withdrawn during retirement. Whereas after-tax dollars fund Roth IRAs. That means you pay tax now for tax-free growth and withdrawals later on.
Most people choose between traditional and Roth IRAs. According to Clark Howard, author and host of The Clark Howard Podcast, future taxes should play a big role in this decision.
“The biggest difference between a traditional IRA and a Roth IRA is the treatment of taxes,” Howard says. “ln general, tax rates are likely to go up over the years no matter which political party is in power. That means it may make more sense to skip the tax deduction you get up front with a traditional IRA to avoid tax later by investing with a Roth IRA.”
Our traditional IRA vs. Roth IRA comparison guide examines fees, investment strategies, tax advantages, and more to provide a closer IRA comparison. It’s common for people to have both types of IRAs for double the tax benefits.
However, a SEP or SIMPLE IRA may be a better option for small businesses or self-employed people.
Withdrawals and distribution
You’ll want to wait until at least 59 ½ to withdraw funds on all IRA types. Withdrawals before this point face a 10% penalty, one of the most significant IRA withdrawal rules and penalties. There are some exceptions on Roth IRAs if you’ve funded it with a rollover, so talk to your tax advisor if you plan to withdraw early from this type of account.
The tax treatment of an IRA depends on the type of account. With traditional, SIMPLE, and SEP IRAs, contributions are tax-deductible, and you fund the account with pre-tax dollars. With Roth IRAs, you contribute post-tax dollars — or money you’ve already paid income taxes on. This allows for tax-free withdrawals in retirement.
“IRAs are either taxed at the beginning or the end,” says Christy Matzen, CFP, senior manager and global planning for Northstar. “When you make a contribution, you can pay tax on the dollars before you put it into the account — this will let you take the money out tax-free, or you can take a tax deduction when you make the contribution, but then the money will be taxed when you take it out.”
Required minimum distributions (RMDs)
Your Required Minimum Distribution (RMD) is the minimum amount you must start withdrawing from your IRA based on your birthdate. Generally, you must start withdrawing from your IRA by April 1 of the following year when you turn 72. If your birthdate is after December 31, 2022, then your RMD is age 73.
After the first required year, you must continue making subsequent annual withdraws by December 31. How much you withdraw depends on the total value of your account and life expectancy.
IRA account FAQs
The difference between traditional and Roth IRAs is that a traditional IRA is funded by pre-tax dollars, and a Roth IRA is funded by after-tax dollars. With a traditional IRA, you only pay tax on the amount withdrawn during retirement, which is especially helpful if you are in a lower tax bracket. On the other hand, Roth IRAs grow tax-free and have tax-free withdrawals, which is great if you expect your income to be higher in your post-working years.
You can contribute up to $7,000 to a traditional or Roth IRA in 2024. Individuals age 50 or older can contribute up to $8,000. You can contribute up to $16,000 (or $19,500 if you’re 50 or older) to a SEP IRA. For SIMPLE IRAs, you can contribute $69,000 or 25% of your compensation, whichever is less.
Anyone with earned income is eligible to open an IRA. However, you can only open one of each type. There are no age restrictions on IRAs either. For Roth IRAs, your modified adjusted gross income (MAGI) must be less than $161,00 for single filers to qualify (less than $240,000 for married couples filing jointly).
You can start withdrawals from your IRA without penalties at age 59 1/2. There are exceptions to this rule, however, as certain hardship guidelines allow penalty-free early withdrawals. For example, the loss of a job or permanent disability may allow you to withdraw early from your IRA without incurring the 10% penalty fee.
Required Minimum Distributions (RMDs) are the mandatory withdrawals you must start taking from your IRA during retirement. You must start taking RMDs by April 1 of the year following your 72 birthdate (73 if your birthdate is after December 31, 2022).
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