How does an IRA work and what is it?

An IRA is a tax-favored savings plan accessible to anyone with earned income, unlike 401(k) plans which are employer-sponsored.

In September 2023, approximately $12.6 trillion was invested in IRAs, as per the Investment Company Institute.

CNBC Select provides a comprehensive guide to various IRAs, including who is eligible, how much you can contribute, and the tax implications.

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How does an IRA work?

An IRA enables you to invest tax-free money into a variety of asset classes, such as stocks, bonds, and mutual funds, resulting in more investment opportunities.

Earned income holders can open an IRA through a bank, robo-advisor, brokerage, or other financial institution, but there are annual contribution limits and a waiting period of 59 ½ before withdrawals can be made without penalty, as per the IRS.

If you have a job-sponsored retirement plan, you may be able to deduct all or part of your IRA contributions from your taxable income, depending on your filing status and income level.

You can typically roll over money from an employer-sponsored retirement account, such as a 401(k), into an IRA while maintaining its tax-deferred status.

Types of IRAs

Several types of IRAs exist, each with distinct rules regarding contributions, taxation, and distributions. It is possible to possess multiple IRA accounts; however, annual contribution limits are additive.

Traditional IRA

The most common type of IRA in the US is the traditional IRA, with 31% of households owning one, according to a February 2024 report from the Investment Company Institute. Contributions to traditional IRAs can reduce your taxable income for that year, but there is a $7,000 contribution limit in 2004 ($8,000 if you're 50 or older). When you withdraw funds from a traditional IRA later, you'll owe taxes on the entire amount being withdrawn.

Withdrawing money from your IRA before the age of 59½ often results in a 10% penalty. From the age of 73, individuals are required to make withdrawals, known as required minimum distributions (RMDs).

Vanguard provides traditional and Roth IRAs with no commission fees for stock and exchange-traded fund trades, no brokerage fee if you sign up for e-statements, and no transaction fees for over 3,000 mutual funds. Additionally, the Vanguard Digital Advisor robo-advisor is available for a 90-day free trial.

Roth IRA

Unlike other IRAs, contributions to Roth IRAs are taxed before they're deposited, which can be useful if you expect to be in a higher tax bracket when you retire. However, Roth IRAs are not subject to RMDs but come with income caps: $153,000 for individuals, $228,000 for married couples filing jointly, and $10,000 for married couples filing separately.

Fidelity Investing provides traditional, Roth, and rollover IRAs with no minimum account opening fee. If your account balance exceeds $25,000, you receive complimentary access to Fidelity advisors.

SEP IRA

Self-employed workers and small business owners can set up a traditional IRA through a Simplified Employee Pension (SEP)-IRA, with employers contributing to the plan and all eligible employees receiving equal contributions.

In order to be eligible for a SEP-IRA, you must meet certain criteria, including being at least 21 years old, having worked at your company for three of the past five years, and earning at least $750 in taxable income.

SIMPLE IRA

A SIMPLE IRA is a savings incentive match plan aimed at businesses with 100 or fewer employees. Employers can either make a mandatory contribution of 2% of an employee's income or a dollar-for-dollar match of their contribution, up to 3%. To be eligible for a SIMPLE IRA, employees must receive at least $5,000 in the current year, as well as two prior years. Additionally, employees can contribute to a traditional or Roth IRA.

How to open an IRA

You can open an IRA at a bank, brokerage, or other financial institution if you have earned income. It's important to shop around for a firm with fees, customer service, and a track record that makes you feel comfortable.

Charles Schwab provides traditional, Roth, and rollover IRAs with no fees or minimums, as well as a vast selection of commission-free stocks, options, and exchange-traded funds. For those who prefer a hands-off approach, the Schwab Intelligent Portfolios robo-advisor offers automatic rebalancing and tax-loss harvesting.

The investing app Robinhood provides an unlimited 1% match on IRA transfers to a Robinhood traditional or Roth IRA, in addition to allowing deposits of up to $1,000 to be invested immediately and offering a range of investment recommendations.

Contribution limits

The IRS sets a limit on annual IRA investments, which varies by account type. For the 2024 tax year, the limit on traditional and Roth IRAs is $7,000 ($6,500 for 2023). For individuals 50 or older, the limit is $8,000 in 2024 ($7,500 for 2023).

The 2024 limit for a SEP-IRA is either 25% of an employee's income or $69,000, whichever is less. (The dollar limit for tax year 2023 is $66,000.)

In tax year 2024, the maximum contribution limit for SIMPLE IRAs is $16,000, while in 2023 it is $15,500. Additionally, individuals aged 50 and above can make an extra $3,500 catch-up contribution.

IRA vs. 401(k)

Both IRAs and 401(k)s are typically tax-deferred, but the former is opened by the individual while the latter is offered by employers. Having both an IRA and a 401(k) can help diversify your portfolio and safeguard you from market fluctuations.

While traditional IRAs provide more investment options and allow for continued contributions regardless of job changes, they lack employer matching and have lower contribution limits. Additionally, unlike 401(k)s, traditional IRAs do not allow for loans to be taken out against the account.

When can I withdraw from my IRA?

Starting at age 59½, you can make penalty-free withdrawals (qualified distributions) from a traditional IRA. However, if you withdraw money before then, you'll be subject to a 10% penalty in addition to standard income taxes.

There are a few exceptions, such as paying for higher education, medical expenses, the birth/adoption of a child, or recovering from a disaster.

According to the IRS, if you have a Roth IRA, you must keep it open for at least five years, even if you're over 59½. If you make an early withdrawal from a Roth IRA that's at least five years old, you only pay taxes and penalties on any earnings that have accrued. For example, if you contributed $10,000 to your IRA and it's earned $2,000 interest, you could withdraw up to $10,000 without a fee.

Some exceptions to penalties on Roth IRAs include first-time homebuyers and higher education expenses.

Withdrawing from a SIMPLE IRA early comes with a penalty. If it's within two years of account opening, the penalty increases.

Required minimum distributions

Starting at age 73, you must withdraw a minimum amount from your IRA annually. Roth IRAs do not require these distributions. The amount you must withdraw depends on your age, marital status, and the total amount in all your IRAs. You can choose to take your RMD from one account or multiple accounts.

Bottom line

An IRA is a valuable tool for individuals seeking to increase their retirement savings beyond the standard 401(k). Contributions to an IRA can be made as long as income is earned, and they do not require employer sponsorship. It is crucial to understand the various types of IRA in order to make an informed financial decision.

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