What Is an Individual Retirement Account (IRA)?
An individual retirement account (IRA) is a savings account with tax advantages that individuals can use to save and invest long-term.
Like a 401(k) account that an employee obtains as a benefit from their employer, an IRA is designed to encourage people to save for retirement. Anyone who has earned income can open an IRA and enjoy the tax benefits these accounts offer.
You can open an IRA through a bank, an investment company, an online brokerage, or a personal broker.
- IRAs are retirement savings accounts with tax advantages.
- Types of IRAs include traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.
- Money held in an IRA usually can't be withdrawn before age 59½ without incurring a hefty tax penalty of 10% of the amount withdrawn.
- There are annual income limitations for deducting contributions to traditional IRAs and for contributing to Roth IRAs.
- IRAs are meant to be long-term retirement savings accounts. If you take money out early, you defeat that purpose by diminishing your retirement assets.
Anyone with earned income can open and contribute to an IRA, including those who have a 401(k) account through an employer. The only limitation is on the combined total that you can contribute to your retirement accounts in a single year while still getting the tax advantages.
When you open an IRA, you can choose to invest in a wide range of financial products, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds. There are even self-directed IRAs (SDIRAs) that 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.
There are several kinds of IRAs, including traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. Each has different rules regarding eligibility, taxation, and withdrawals. Individual taxpayers can establish traditional and Roth IRAs, and small business owners and self-employed individuals can set up SEP and SIMPLE IRAs. An IRA must be opened with an institution that has received Internal Revenue Service (IRS) approval to offer these accounts. Choices include banks, brokerage companies, federally insured credit unions, and savings and loan associations.
Because IRAs are meant for retirement savings, there is usually an early withdrawal penalty of 10% if you take money out before age 59½. There are some notable exceptions—withdrawals for educational expenses, for example, and for first-time home purchases, among others. If your IRA is a traditional account rather than a Roth account, you will owe income tax on an early withdrawal.
What Counts As Income?
You can only contribute to an IRA with earned income that meets the IRA definition. Income from interest and dividends, Social Security benefits, or child support does not count.
What Are the Different Types of IRAs?
Following is a breakdown of the different types of IRAs and the rules regarding each.
In most cases, contributions to traditional IRAs are tax-deductible. So if you put $4,000 into an IRA, your taxable income for the year decreases by that amount. Then, when you withdraw the money in retirement, it is taxed at your ordinary-income tax rate. In that way, your money grows on a tax-deferred basis in a traditional IRA.
For 2021 and 2022, the annual individual contributions to traditional IRAs cannot exceed $6,000 in most cases. If you are 50 or older, you can contribute up to $7,000 per year (the extra $1,000 is considered a catch-up contribution).
If you don't have a retirement plan at work, your traditional IRA contributions are fully deductible. But if you (or your spouse, if you are married) have a retirement plan at work, such as a 401(k) or 403(b), your modified adjusted gross income (MAGI) determines whether and how much of your traditional IRA contributions can be deducted. In 2021, if you are single or file as head of household and have a retirement plan at work, your traditional IRA contributions are fully deductible if your MAGI is below $66,000. If you are married filing jointly, your MAGI must be less than $105,000. From there, you begin to lose deductions as your MAGI increases.
For 2022, the IRS changed the income phaseout range for deducting contributions to a traditional IRA for investors with retirement plans at work. The phaseout range for married couples increased from $105,000–$125,000 (2021) to $109,000-$129,000, and for single taxpayers or heads of households from $66,000–$76,000 (2021) to $68,000-$78,000.
If you contribute to an IRA and are married to someone covered by a workplace plan, but you are not, the phaseout range in 2022 goes up to $204,000 to $214,000, up from $198,000 to $208,000 in 2021.
Use this chart to figure out where you fit.
|Deduction Limits If You Have a Retirement Plan at Work|
|Filing Status||2021 MAGI||2022 MAGI||Deduction|
|Single or Head of Household|
|$66,000 or less||$68,000 or less||Full deduction up to your contribution level|
|More than $66,000 but less than $76,000||More than $68,000 but less than $78,000||Partial deduction|
|$76,000 or more||$78,000 or more||No deduction|
|Married Filing Jointly|
|$105,000 or less||$109,000 or less||Full deduction up to your contribution level|
|More than $105,000 but less than $129,000||More than $109,000 but less than $129,000||Partial deduction|
|$125,000 or more||$129,000 or more||No deduction|
|Married Filing Separately|
|Less than $10,000||Less than $10,000||Partial deduction|
|$10,000 or more||$10,000 or more||No deduction|
Roth IRA contributions are not tax-deductible, but qualified distributions are tax-free. You contribute to a Roth IRA using after-tax dollars, but you do not have to pay any taxes on investment gains. When you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roth IRAs also do not have RMDs. If you don't need the money, you don't have to take it out of your account. You can still contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.
Roth IRA contribution limits for 2020 and 2021 tax years are the same as for traditional IRAs. However, there is a catch. There are income limitations for contributing to a Roth IRA. The phaseout range for single filers is between $125,000 and $140,000 in 2021 and $129,000 and $144,000 in 2022. For married couples filing joint taxes, the phaseout range is $198,000 to $208,000 in 2021, and $204,000 and $214,000 in 2022.
|Income Limits for Contributing to a Roth IRA|
|Filing Status||2021 MAGI||2022 MAGI||Contributions|
|Single or Head of Household|
|Less than $125,000||Less than $129,000||Up to the limit|
|$125,000 to less than $140,000||$129,000 to less than $144,000||Reduced amount|
|$140,000 or more||$144,000 or more||Zero|
|Married Filing Jointly or Qualifying Widow(er)|
|Less than $198,000||Less than $204,000||Up to the limit|
|$198,000 to less than $208,000||$204,000 to less than $214,000||Reduced amount|
|$208,000 or more||$214,000 or more||Zero|
|Married Filing Separately|
|Less than $10,000||Less than $10,000||Reduced amount|
|$10,000 or more||$10,000 or more||Zero|
Self-employed individuals such as independent contractors, freelancers, and small-business owners, can set up SEP IRAs. The acronym SEP stands for simplified employee pension.
A SEP IRA adheres to the same tax rules for withdrawals that a traditional IRA does. For 2022, SEP IRA contributions are limited to 25% of compensation or $61,000, whichever is less.
Business owners who set up SEP IRAs for their employees can deduct their contributions on behalf of employees. However, the employees cannot contribute to their accounts, and the IRS taxes their withdrawals as income.
The SIMPLE IRA is also intended for small businesses and self-employed individuals. The acronym SIMPLE stands for savings incentive match plan for employees. This type of IRA follows the same tax rules for withdrawals as a traditional IRA.
Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions as well. All the contributions are tax-deductible, potentially pushing the business or employee into a lower tax bracket.
The SIMPLE IRA employee contribution limit in 2022 is $14,000, up from $13,500 in 2021, and the catch-up limit (for workers aged 50 and older) is $3,000 for 2022, the same as it was in 2021.
Revenue Ruling 2008-5
In 2008, the IRS issued Revenue Ruling 2008-5, which states that IRA transactions can trigger the wash-sale rule. Should shares be sold in a non-retirement account, followed by substantially identical shares purchased in an IRA within a 30-day period, the investor cannot claim tax losses for the sale. The investment's basis in the individual's IRA won't be increased either.
Required Minimum Distributions
Starting at age 72, holders of traditional IRAs must begin taking required minimum distributions (RMDs), which are based on the account size and the person's life expectancy. Failure to do so may result in a tax penalty equal to 50% of the amount of the required distribution.
In 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act increased the age requirement of taking RMDs from 70½ to 72. It also eliminated the age limit at which a person can contribute to an IRA, which was 70½. A person of any age with earned income can now contribute to an IRA.
Comparing IRA Options
Use the chart below to get a better sense of how the different IRAs work.
Note: To view the full chart, use the slider at the bottom to see the column at the far right.
|Comparing IRA Types|
|IRA Type||Employee Contribution Limit (2022)||Tax Deductible Contributions?||Tax-Free Distributions?||Subject to Required Minimum Distributions Beginning at Age 72?||Who Can Establish|
|Traditional||$6,000; $7,000 if age 50 or older||Yes, but individual deduction amounts are based on income, filing status, and retirement plan coverage through your employer||No||Yes||Individual taxpayers and couples|
|Roth||$6,000; $7,000 if age 50 or older||No||Yes||No||Individual taxpayers and couples, subject to MAGI limitations|
|SEP||The lesser of 25% of compensation or $61,000||Business deductions for employee contributions are limited to the lesser of your total contributions or 25% of employees’ compensation Self-employed individuals must use a special formula to calculate the amount of contributions they can deduct||No||Yes||Small-business owners and self-employed individuals|
|SIMPLE||$14,000; $17,000 if age 50 or older||All contributions made to employees’ SIMPLE IRAs by the plan owner are tax deductible Self-employed individuals can also deduct contributions made to their own SIMPLE IRA||No||Yes||Small-business owners and self-employed individuals|
What Are the Different Types of IRAs?
The most basic is the traditional IRA or the Roth IRA. A traditional IRA gives you an immediate tax benefit: The amount you deposit is deductible from your gross income that year, up to annual limits. You'll owe income taxes on the money only after making a withdrawal. If you have a Roth IRA, you pay income taxes that year on the amount you contribute. You won't owe any taxes down the road when you withdraw the money.
Other types of IRAs are aimed at people in specific circumstances: SEP and SIMPLE IRAs are intended for business owners or self-employed people like contractors and freelancers.
Can I Contribute to Multiple Retirement Accounts in the Same Year?
Yes, but you must be sure that the combined contributions to all your IRAs do not exceed the annual limits set by the IRS. If you have a 401(k) plan through an employer, you can even contribute to both the 401(k) plan and an IRA. Just stay within the total limit for the year.
Can I Withdraw Money Early From an IRA?
You can if your need is urgent but be prepared for a whopping 10% tax penalty on top of the income taxes due on the balance. That said, there are allowable withdrawals for certain expenses, like a first-time home purchase or educational expenses.
What Investments Can I Hold in an IRA?
Your choice is vast, with banks, investment companies, and brokerages all vying for your business. Each will offer a selection of IRA accounts, each made up of a mix of investments that may include mutual funds, stocks, exchange-traded funds (ETFs), bonds, and more.
You also have the option of opening a self-directed account that allows you to make all the investment choices. The IRS forbids only the riskiest types of investments like collectibles and precious metals.
What Happens to My IRA When I Die?
All IRA accounts require a named beneficiary. If you die before your IRA assets are exhausted, they will pass to your beneficiary. (For a married couple, the beneficiary is the holder's spouse, unless the spouse agrees in writing that another beneficiary is named.) If the beneficiary is under retirement age, they will be subject to the same IRA distribution and withdrawal rules.
Correction—Nov. 19, 2021: A previous version of this article misstated the SIMPLE IRA employee contribution limit in 2022.
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