Everything You Need to Know About Individual Retirement Accounts (2024)

There are several types of IRAs that I’ll discuss below, including traditional IRAs, Roth IRAs, SIMPLE IRAs, SEP IRAs, and more, as well as how to open one, recommendations for which type works for you, and benefits of IRAs.Everything You Need to Know About Individual Retirement Accounts

Admit it. You’re curious about individual retirement accounts or IRAs. You know they can help you save for your future. Still, they’re a little confusing at times.

I know because I receive many questions about IRAs on my podcast each week, and I suspect I’ll hear more, as the freelance economy expands and workers look to alternative ways to save for retirement beyond traditional 401(k)s offered by employers.

Key Takeaways

An IRA is an investment account that allows workers to store and invest their earned income to fund their retirement.
IRAs are meant for retirement. Because of this, if you withdraw from your IRA account before you turn 59 ½, you may face a 10 percent early withdrawal penalty.
Once you turn 70 ½, you may be subject to Required Minimum Distributions (RMDs), or you might face a 50 percent penalty tax on every dollar.
There are numerous types of IRAs with differing tax liabilities that you can make contributions to, depending on your employment status.

Here are some frequently asked questions and answers about IRAs.

What is an IRA?

The IRA definition is very simple. An individual retirement account, or IRA, is an investment account designed to help workers sock away some of their earned income for retirement. Earned income is defined as wages, salaries, tips, and other kinds of claimed taxable income produced while working for someone else or yourself.

How does an IRA work?

What is an IRA account and how do they work? When it comes to IRAs, there are two main types: traditional and Roth, and both work in different ways. Almost anyone can open one of these IRAs, as long as you have proven income. So, whether you’re looking for IRAs for freelancers or IRAs for part-time workers, investing in your future is possible. IRS.gov outlines how each IRA plan works, including contribution limits and income limits.

Traditional IRA

With a traditional IRA, you can make contributions that you can deduct on your current tax return. However, once you withdraw your contributions in retirement, they will be subject to taxation based on the tax bracket you’re in during retirement.
Contribution limits for traditional IRAs in 2019 are $6,000 or $7,000 if you’re 50 years old or older.
The income limits for a traditional IRA in 2019 go as follows:
- If you’re married filing jointly and covered by a retirement plan at work, you can get a full deduction if your modified AGI (adjusted gross income) is $103,000 or less, a partial deduction if your modified AGI is more than $103,000 but less than $123,000, and no deduction if your modified AGI is more than $123,000.
- If you’re married filing jointly and your spouse is covered by a retirement plan at work, you can receive a full deduction if your modified AGI is less than $193,000, a partial deduction if your modified AGI is more than $193,000 but less than $203,000, and no deduction if your modified AGI is more than $203,000.
- If you’re single or head of household and are covered by a retirement plan at work, you can receive a full deduction if your modified AGI is $64,000 or less, a partial deduction if your modified AGI is more than $64,000 but less than $74,000, and no deduction if your modified AGI is $74,000 or more.
- If you’re married filing jointly and both you and your spouse are covered by a retirement plan at work, a full deduction is unavailable, and you will receive a partial deduction if your modified AGI is less than $10,000, and no deduction if your modified AGI is more than $10,000.

The income limits for a traditional IRA in 2020 go as follows:
- If you’re married filing jointly and covered by a retirement plan at work, you can get a full deduction if your modified AGI is $104,000 or less, a partial deduction if your modified AGI is more than $104,000 but less than $124,000, and no deduction if your modified AGI is more than $124,000
- If you’re married filing jointly and your spouse is covered by a retirement plan at work, you can receive a full deduction if your modified AGI is less than $196,000, a partial deduction if your modified AGI is more than $196,000 but less than $206,000, and no deduction if your modified AGI is more than $206,000
- If you’re single or head of household and are covered by a retirement plan at work, you can receive a full deduction if your modified AGI is $65,000 or less, a partial deduction if your modified AGI is more than $65,000 but less than $75,000, and no deduction if your modified AGI is $75,000 or more
- If you’re married filing jointly and both you and your spouse are covered by a retirement plan at work, a full deduction is unavailable, and you will receive a partial deduction if your modified AGI is less than $10,000, and no deduction if your modified AGI is more than $10,000

Roth IRA

Unlike a traditional IRA where your current tax bill is reduced based on the amount of money you contribute, contributions to a Roth IRA are not tax-deductible. However, in this type of individual retirement account, your contributions grow tax-free, and once you’re in retirement, you can withdraw your contributions tax-free, as well.
The contribution limits for a Roth IRA in 2019 and 2020 are $6,000 or $7,000 if you’re 50 years or older.
Income limits for a Roth IRA in 2019 go as follows:
- If you’re a qualifying widow(er) or married filing jointly, you can make a full contribution if your modified AGI is $193,000 or less, a reduced contribution if your modified AGI is between $193,000 to $202,999, and no contribution if your modified AGI is $203,000 or more.
- If you’re single, head of household, or married filing separately and didn’t live with your spouse during the year, you can make a full contribution if your modified AGI is less than $122,000, a reduced contribution if your modified AGI is between $122,000 and $136,999, and no contribution if your modified AGI is $137,000 or more.
- If you’re married filing separately and did live with your spouse at any point during the year, you can’t make a full contribution, can have a reduced contribution if your modified AGI is less than $10,000, and no contribution if your modified AGI is $10,000 or more.

Income limits for a Roth IRA in 2020 go as follows:
- If you’re a qualifying widow(er) or married filing jointly, you can make a full contribution if your modified AGI is $196,000 or less, a reduced contribution if your modified AGI is between $196,000 to $205,999, and no contribution if your modified AGI is $206,000 or more.
- If you’re single, head of household, or married filing separately and didn’t live with your spouse during the year, you can make a full contribution if your modified AGI is less than $124,000, a reduced contribution if your modified AGI is between $124,000 and $138,999, and no contribution if your modified AGI is $139,000 or more.
- If you’re married filing separately and did live with your spouse at any point during the year, you can’t make a full contribution, can have a reduced contribution if your modified AGI is less than $10,000, and no contribution if your modified AGI is $10,000 or more.

Benefits of IRAs

There are many benefits you can take advantage of when opening an IRA. These benefits include:

Rolling over your IRA when you change jobs or open a new IRA account
A lowered adjusted gross income
Using your contributions to create an IRA emergency fund
Tax-free growth on the contributions you make

Traditional IRAs vs. Roth IRAs

The traditional and Roth are the most popular types of IRA accounts (more on some other IRA versions in a moment). The biggest difference is the tax advantage each provides. Below, we’ll go over traditional vs. Roth IRAs.

Traditional IRAs

Contributions made today to a traditional IRA are tax-deductible, thus, helping you to reduce your taxable income.
Future withdrawals are subject to income tax.
Anyone can contribute to a traditional IRA, regardless of how much they earn.
You can begin withdrawing money at age 59 1/2 without penalty. Before that age, the IRS will charge you a 10% early withdrawal penalty, and you must pay income tax on that withdrawal at your current tax rate.
For the 2019 and 2020 tax years, you can contribute up to $6,000 in a traditional IRA. If you are 50 or older, you can make an extra “catch-up” contribution of $1,000.

Roth IRAs

Contributions to a Roth IRA are not tax-deductible. Instead, you can withdraw from the account tax-free beginning at age 59 1/2 (as long as it’s been at least five years since your first contribution).
Like a traditional IRA, you can contribute up to $6,000 in a Roth. If you are 50 or older, you can make an extra “catch-up” contribution of $1,000.
There are income limitations to qualify, however. If you are married and filing taxes jointly, the IRS says you can fully contribute to a Roth IRA, as long as your adjusted gross income is no more than $193,000. Single filers must earn less than $122,000 to contribute up to the limit.
In 2020, however, your income limitations change. If you’re married filing jointly, you can fully contribute to a Roth IRA as long as your adjusted gross income is less than $196,000. If you’re a single filer, you must earn less than $124,000 to contribute up to the limit.
Contributions to a Roth IRA can be withdrawn penalty-free at any time, once the account has been open for five years. If, however, you dip into your earnings before 59 1/2 years old, that money is then subject to income taxes and a 10% early withdrawal penalty.
Roth IRAs aren’t subject to required minimum distributions (RMDs), which means the balances in your account will receive tax-deferred growth for as long as you want.

Different Types of IRAs

There are a variety of different types of IRAs besides the traditional and Roth IRAs. These types of IRAs include:

SEP IRA

For individual business owners, there is the SEP (Simplified Employee Pension) IRA. The SEP lets business owners contribute to their retirement, as well as the retirement of their employees. SEP IRAs generally follow the same guidelines as traditional IRAs. One big difference: You can contribute up to 25% of your compensation or $56,000 in 2019, and $57,000 in 2020, a much larger amount than with traditional IRAs.

Self-Directed IRA

There’s also another category called self-directed IRAs. Unlike traditional IRAs that limit investors to mainly stocks, funds, and bonds, this alternative account allows for a more creative, broader range of assets, including real estate, private equity, foreign companies, precious metals, and even racehorses.

Spousal IRA

In order to open an IRA, you need to earn an income. However, a spousal IRA is different in that a non-working spouse can be an owner of a spousal IRA. With a spousal IRA, the non-working spouse is able to make contributions to a traditional or Roth IRA based on the working spouse’s income. According to the IRS, the amount of your total combined contributions cannot exceed the taxable compensation reported on your joint tax return, with the maximum contribution being $6,000 (or $7,000 if you’re 50 or older).

Inherited IRA

If you have an IRA, you can list people as a beneficiary, which will create an inherited or beneficiary IRA. If you inherit an IRA from your spouse after they pass, you can treat it as your own by designating yourself as the account owner. You can also roll it over into a traditional IRA, or treat yourself as the beneficiary rather than as treating the IRA like it’s your own.

If you’re not a spouse and you inherit an IRA, say from your parent, grandparent, uncle, aunt, or friend, you cannot treat the IRA as your own. This means you can’t make any contributions or roll it over into another IRA. Instead, you can make a trustee-to-trustee transfer in the name of the deceased owner for the benefit of yourself.

If the IRA is a Roth IRA, you can withdraw contributions tax-free, as long as the Roth account has been open for five or more years at the time the account owner passed. However, if the IRA is a traditional IRA, you may have to pay taxes when you withdraw money from the account. The taxes are determined at your income tax rate, not the deceased account owner’s.

SIMPLE IRA

A SIMPLE IRA plan (Savings Incentive Match Plan for Employees) is a plan that allows employers and employees to contribute to a traditional IRA that’s set up for employees. A SIMPLE IRA is usually used by employers of small businesses who don’t sponsor a current retirement plan. Employees can choose to have portions of their salary contributed to their IRA, while employers can either make nonelective or matching contributions. SIMPLE IRA plans follow the same rules as traditional IRAs.

Backdoor Roth IRA

Roth IRAs are an attractive option because your money grows tax-free. However, the IRS places income limits if people have a certain modified adjusted gross income. For the 2019 tax year, if you’re married filing jointly and make over $203,000 or single making over $137,000, you cannot contribute to a Roth IRA. In 2020, those limits change slightly, to $206,000 if you’re married filing jointly, and $139,000 if you’re single.

If you’re making more than these income limits, there is a way to store money in a Roth IRA—all you have to do is go through the backdoor. A backdoor Roth IRA isn’t a specific IRA Plan. Instead, it’s a practice that allows you to bypass the income limits. To sidestep these limits, all you have to do is open a traditional IRA, convert your traditional IRA into a Roth IRA, and pay your taxes once you convert.

IRA FAQs

Q: How does my money get invested in an IRA?

A: You can choose to invest your money in a variety of ways – cash, stocks, CDs, bonds, mutual funds, exchange-traded funds, index funds, etc.

Q: Which is better for me? A Roth or Traditional IRA?

A: If you expect to be in a lower tax bracket in retirement, then a traditional IRA may be best. Of course, if you earn more than the Roth’s income limit, your only choice between the two is the traditional IRA.

If you already have a 401(k) or another type of employer-sponsored retirement account where contributions are tax-deductible – and you’re looking to diversify your tax exposure in retirement – a Roth IRA can be a better vehicle for that purpose.

Finally, if you desire more financial liquidity in your life, then a Roth IRA may be a wiser choice. You can, as stated earlier, withdraw your contributions penalty-free at any time from a Roth IRA (once you’ve established the account for 5 years).

Q: Are there age restrictions to opening an IRA?

A: There is no minimum age limit to contribute to a Roth IRA, but you must be younger than 70 1/2 to open a traditional IRA.

Q: How can I open up an account? Does it cost anything to open an IRA?

A: You can open an account at any number of financial institutions. You can transfer money from a current bank account or existing IRA or by rolling over money from a 401(k) from a previous employer. Typically, there are no fees when it comes to opening an IRA. However, some banking institutions may require you to have a minimum amount of money to open an account.

Q: IRA versus 401(k): Which one is better?

A: In general, the ideal retirement savings vehicle is an employer-sponsored account like a 401(k) that provides a match. That’s more or less free money. If you’re already putting the maximum towards your 401(k) and receiving a company match – and want to continue to invest – then an IRA can be the next best vehicle. For 2017, you can defer as much as $18,000 of your paycheck to your 401(k). If you’re 50 or older, you can contribute an additional $6,000.

From the Mint team: Take the first step to finding the right IRA for you by visiting Mint’s IRA information page.

Have a question for Farnoosh? You can submit your questions via Twitter @Farnoosh, Facebook, or email at farnoosh@farnoosh.tv (please note “Mint Blog” in the subject line).

Farnoosh Torabi is America’s leading personal finance authority hooked on helping Americans live their richest, happiest lives. From her early days reporting for Money Magazine to now hosting a primetime series on CNBC and writing monthly for O, The Oprah Magazine, she’s become our favorite go-to money expert and friend.