Saving for retirement is critical to ensure financial stability for maintaining your lifestyle and covering expenses once you stop working. One of the most popular ways to save for retirement is through an individual retirement account (IRA).

An IRA is a tax-advantaged investment account, created under the Employee Retirement Income Security Act (ERISA) in 1974, designed to encourage long-term savings. By offering tax benefits, IRAs help individuals build their retirement funds more efficiently.

Types of IRAs

There are many types of IRAs, each with their own unique benefits. The most common IRAs are:

Traditional IRA

A Traditional IRA is funded with pre-tax income, which lowers your modified adjusted gross income (MAGI) and tax liability in the years you contribute. Earnings in your Traditional IRA grow tax-deferred until you’re eligible to withdraw funds without penalty at the age of 59 ½.

Roth IRA

A Roth IRA is funded with post-tax income, allowing the funds to grow tax-free. Withdrawals made after the age of 59½ are also tax-free. Individuals who expect to be in a higher tax bracket during retirement prefer to contribute to a Roth IRA to avoid paying taxes on their account distributions in their highest earning years.

Rollover IRA

A Rollover IRA is not a distinct type of account and can be a type of Traditional or Roth IRA. Investors “roll over” the funds from their previous employer-sponsored retirement plan to either a Traditional or Roth IRA based on the tax status of their former plan. This action allows investors to gain control of the investment choices offered by their new IRA.

Other IRAs

Simplified employee pension (SEP) IRA: A SEP IRA is a workplace retirement savings plan for self-employed individuals and small business owners. Only employers can make contributions in this type of account, and the tax implications resemble those of a Traditional IRA. Contributions can be up to 25% of an employee’s salary or $66,000, whichever is less.

Savings Incentive Match Plan for Employees (SIMPLE) IRA: A SIMPLE IRA is also a type of workplace retirement savings plan for small business owners. However, both employers and employees can contribute to this plan. SIMPLE IRAs have a mandatory employer match of up to 3% of the employee’s pay or contribution equal to 2% of the employee’s compensation, even if the employee doesn’t contribute. Tax implications in a SIMPLE IRA account are similar to those of a Traditional IRA.

Investment Opportunities in IRAs

Stocks: Investing in stock represents equity ownership in a company and can potentially deliver price appreciation and dividends to investors.

Bonds: Bonds are a form of debt issued by a company or government. Bond investors typically earn interest on the investment amount and are paid back their initial investment when the bond matures.

Money Market Funds: Money market funds are a diversified basket of investments, typically highly liquid, short-term securities. These funds provide investors with higher interest-yielding investment opportunities while remaining low-risk and easy to sell.

ETFs: ETFs also provide investors with a diversified basket of assets. Due to their operating structure, ETFs typically provide better tax advantages than mutual fund counterparts.

Options: Options are a type of financial derivative often used in high-risk trading strategies. They are available in only some IRAs for sophisticated investors.

IRA Contribution and Withdrawal Rules

IRAs are designed to incentivize retirement saving through tax benefits, but they also come with specific contribution and withdrawal rules varying by account type:

Income: Investors must have earned income during the year they wish to contribute to a Traditional or Roth IRA. Traditional IRAs do not have an income cap, but if you’re covered by an employer-sponsored plan, your ability to deduct contributions may be limited. Roth IRAs, on the other hand, have income limits—single filers with a MAGI over $161,000 and joint filers with a MAGI over $240,000 are ineligible to contribute.

Age: There are no age limits for contributing to an IRA as long as you have earned taxable income for the year.

Contributions: The IRS adjusts investor contribution limits each year to align with inflation. In 2024, investors under 50 can contribute a total of $7,000 or $8,000 if they are over 50. These contribution limits apply to your total contributions across all IRA accounts, including your Traditional and Roth IRAs.

Withdrawals: With a Traditional IRA, you can begin penalty-free withdrawals at age 59½, though you’ll still owe income tax on the distributions. Early withdrawals incur a 10% penalty, along with standard income taxes. At age 72, Required Minimum Distributions (RMDs) begin. For Roth IRAs, withdrawals after age 59½ are tax-free, but early withdrawals of earnings also incur a 10% penalty. However, you can always withdraw Roth contributions tax- and penalty-free. Your brokerage or advisor can help you calculate the exact amount of your RMD.

Both Traditional and Roth IRAs allow specific exceptions to the early withdrawal penalty. If you use the funds for qualified expenses relating to birth or adoption, disability, qualified higher education, first-time homebuying, and select others, you can withdraw without penalty.

Tax considerations of IRAs

Traditional IRA contributions typically benefit investors in a high tax bracket. Deducting your contributions can lower your taxable income for the year.

Roth RIAs are generally meant for investors in a lower tax bracket during the years of their contributions and can save investors when they withdraw their funds tax-free once they reach 59 ½.

What Else to Know About IRAs

Beneficiaries: Setting up beneficiaries in your IRA removes the uncertainty of transferring your funds after death. You can specify who the beneficiaries are, how much they’re given, and

secondary beneficiaries.

Investing your contributions: Keep in mind that your IRA is merely a vehicle for holding investments. Make sure to invest the funds you contribute—otherwise, they’ll sit in low-interest cash positions, limiting potential growth.

Convenience: If you prefer not to actively manage your IRA, many brokers offer services such as access to financial advisors, robo-advisors, or target-date mutual funds to simplify the process.

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