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Understanding how IRAs work and how they help you save for retirement

November 4, 2022, 4:39 PM UTC
Hourglass filled with coins
You can now contribute more, and save for retirement.
Photo illustration by Fortune; Original photo by Getty Images

Planning for retirement doesn’t have to just include contributing to a 401(k) account—you can supplement your savings by opening an individual retirement account (IRA) as well. Not only do IRAs allow you to save and grow your contributions for retirement, but you can also reduce your tax bill when you contribute. 

The IRS recently announced the contribution limit will increase from $6,000 in 2022 to $6,500 in 2023, further increasing your ability to save for retirement. 

What is an IRA? 

An IRA is an investment account that allows you to save for retirement. Any contributions made to an IRA grow on a tax-deferred basis, which makes it a great option for those looking to grow their funds to use later on when they’re not working. 

There are several types of IRAs—the most common ones being traditional and Roth IRAs—each with varying tax rules and how they’re set up (more on that later). Determining which account suits your unique situation depends on your age, income level, and sometimes occupation, such as if you work for a small business or are self-employed. 

How IRAs work 

Anyone with earned income, including spouses if filing jointly, can open and contribute to an IRA. These types of retirement accounts can be opened in person at banks and credit unions, or online through brokers and investment companies. It’s important to note that IRAs are different from 401(k) retirement accounts, which are employer-sponsored retirement accounts that are self-funded by employees, with the option for employers to match contributions. 

After an IRA is opened, you can choose to invest in a variety of assets like stocks, bonds, mutual funds, and ETFs. Some IRAs allow you to be in control of your own investment decisions, known as self-directed IRAs, while others have automatic investment plans. Financial professionals can help you decide which account type is right for you. 

Withdrawal rules

Because IRAs are designed to help you save for retirement, there is an early withdrawal penalty of 10% of the amount you withdraw prior to reaching age 59½. This penalty was created to encourage you to continue saving for retirement long-term and avoid dipping into the pot too early. But there are some exceptions to this early withdrawal rule, such as death, disability, education, or a first-time home purchase.

On the flip side, there is a penalty for withdrawing from an IRA too late (if you have a Traditional IRA, SEP, or SIMPLE). Generally, after reaching age 72, you are required to begin taking withdrawals from your IRA, known as required minimum distributions (RMDs). Failing to take RMDs results in a 50% penalty of the distribution amount.

Types of IRAs 

There are several kinds of IRAs, and each have their own set of rules for eligibility, withdrawals, and taxation. Here are four kinds of IRAs and how they work:

Traditional

Traditional IRAs are a type of IRA that are funded with pre-tax dollars to help you save for retirement. Traditional IRAs may be a good option for those who anticipate being in the same or lower tax bracket upon retirement since the withdrawals are taxed at the owner’s current income tax rate. 

Eligibility: Anyone with earned income is eligible to contribute to a traditional IRA up to the annual contribution limit.

Contribution limit: The annual contribution limit for IRAs is set at $6,000 in 2022. People aged 50 and older may contribute an additional $1,000 each year to catch up on your retirement savings. The total contribution amount can be split between multiple IRA types, but cannot exceed the total limit in any single year, says Faron Daugs, founder and CEO at Harrison Wallace Financial Group, a financial group with a speciality in personalized retirement planning. 

If you choose to contribute more than the annual limit, excess contributions will be taxed at 6% per year for each year the excess remains in the IRA. If you have accidentally contributed more than your limit, you can avoid the 6% tax by withdrawing the excess contributions and any income earned on the excess amount by the time you file your income tax return. 

Taxation: Contributions made to a traditional IRA are deducted from your total taxable income in the year the payment is made. This means contributions have not been taxed yet. 

Withdrawals: Distributions from a traditional IRA are taxed at the income tax rate you are in at the time of the withdrawal. 

Roth

Roth IRAs are a type of tax-advantaged retirement plan that is funded with after-tax dollars. That means any withdrawals made after age 72 will be tax-free in the year they are distributed. 

Eligibility: Anyone with earned income and qualifying filing status and modified AGI is eligible to contribute to a Roth IRA.

Contribution limit: Roth IRAs do impose annual contribution limits, which is $6,000 in 2022 but this limit may be reduced depending on your modified adjusted gross income (MAGI) and filing status.  For those aged 50 and older, the IRA allows you to contribute an additional $1,000 to catch up on your retirement savings. 

If your contribution is reduced, the IRS created a formula to help you calculate the amount of your contribution limit. 

Taxation: Contributions made to a Roth IRA are included in your total taxable income in the year the payment is made. In other words, the contribution is made using after-tax dollars. 

Withdrawals: Since the contribution was already taxed, any withdrawals made from a Roth IRA are not taxed at the time they are taken out. 

Simplified Employee Pension (SEP)

SEP plans are a type of IRA that’s typically established by an employer for themself or their employees. SEP plans are available to businesses of all sizes and are often chosen because of their low administration costs and simple structure. 

Eligibility: In order for an employee to qualify for a SEP, they must be 21 years of age and have worked for the business for at least three of the last five years and earned an annual income of at least $650 in 2022. 

Contribution limit: Employers can decide how much they want to contribute to their employees' plans up to 25% of their annual compensation, or a maximum of $61,000 in 2022. 

Employers must contribute the same percentage of compensation into all employees' SEP IRAs. 

Taxation: Generally, the employer makes tax-deductible contributions directly into the IRA on behalf of qualifying employees.

Withdrawals: Distributions from SEP IRAs are taxed at your current income tax rate in the year the withdrawal is made. 

Savings Incentive Match Plan for Employees (SIMPLE)

SIMPLE IRA plans are set up by small businesses with 100 or fewer employees. Employees are 100% vested in all of the funds in the SIMPLE IRA, or in other words have complete ownership of the money in the account.

Eligibility: Qualifying employees include those who earned at least $5,000 in compensation in any two years before the current year, and also anticipates to earn $5,000 in the current year.

Contribution limit: Unlike SEP plans, the employee may elect to contribute a portion of their own income to the IRA and the employer is required to match the contribution made by the employee up to 3% of compensation. 

If the employee chooses not to contribute to their own SIMPLE plan, the employer must still contribute 2% of compensation, up to the annual limit of $305,000 in 2022. 

Taxation: Generally, the employer can deduct the amount of their contribution to an employee's SIMPLE IRA from their taxable income in the year the payment was made. 

Withdrawals: Distributions from SIMPLE IRAs are taxed at your current income tax rate for the year the withdrawal is taken out. 

Pros and cons of an IRA 

IRAs can be attractive because they offer a tax-advantaged way to save for retirement. On the other hand, IRAs have relatively low contribution limits and may have strict income limits preventing some participants from benefiting from tax breaks. You should consider the benefits and the downfalls of an IRA before opening an account. 

7 ways to maximize your IRA contributions

When it comes to adding to your IRA, there are additional steps you can take to maximize your contributions. Here are seven ways you can make the most of your money with an IRA.

  1. Start contributing early and be systematic about your investments. Saving for retirement as early as possible gives your savings time to compound interest and grow. While $6,000 may sound daunting to a young adult, especially in today’s world with high costs of housing and inflation impacting their budget, setting aside small dollar amounts when you have extra funds available will allow you to reach that goal overtime.
  1. Contribute the maximum annual amount to your IRA. In 2023, the IRS will begin allowing Traditional and Roth IRA participants to contribute $6,500 annually, up from the current limit of $6,000 in 2022. By maximizing your contribution, you are increasing the investment that earns interest over time, which increases your overall retirement savings.
  1. Take advantage of catch-up contributions. If you are above 50 years old, the IRS allows you to make additional contributions to your IRA. The additional savings have nearly two decades to continue compounding interest before you have to take RMDs, so there is plenty of time to catch up on your retirement savings.  
  1. Meet the contribution deadline. IRA contributions need to be made by the time you file your personal income taxes in mid-April. Depending on the type of IRA you have, your contribution may reduce your overall taxable income and can save you money at tax time. 
    If you made contributions from January to April, you can specify whether the contribution should be applied to the current or previous calendar year. If you have not maxed out your contributions yet, consider applying it to the previous year. But if you reached the maximum contribution limit, be sure to apply it to the current year to avoid an excess contribution tax. 
  1. Claim the Retirement Savings Contributions Credit. Known as the Saver’s credit, the tax credit can be taken for eligible contributions to an IRA if you are at least 18 years old, not currently a student, and cannot be claimed as a dependent on another person’s tax return. Depending on your adjusted gross income on your tax return, the credit can be as high as 50% of the annual contributions to your Traditional or Roth IRA. 
  1. Minimize IRA fees and taxes. When deciding where you want to open your IRA, you should consider what fees you will have to pay throughout the lifetime of the account. If you work with an adviser, they may charge fees for helping you choose your investments, says Daugs. But also, try to avoid fees from the IRS including early withdrawal penalties, excess contribution fees, and failure to take RMDs. 
  1. Consider your tax bracket when deciding between Traditional or Roth. If you are currently in a high tax bracket and plan to be in the same or lower tax bracket in retirement, you should consider opening a Traditional IRA. Traditional IRAs allow you to deduct your IRA contributions from your taxable income in the year it is contributed, so you can benefit from the reduction in your tax bill while you are in a higher tax bracket. 

However, if you are currently in a lower tax bracket than you plan to be in at retirement, you may want the benefit of a tax-free withdrawal that comes with a Roth IRA to lower your tax bill later. 

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