An IRA (Individual Retirement Account) is a tax-advantaged investment tool that people use to set aside funds for retirement savings. There are several types of IRA accounts:
- Traditional IRAs
- Roth IRAs
- SEP IRAs
- SIMPLE IRAs
Table of Content
What is an IRA
- The IRA (Individual Retirement Account) is a tax-advantaged investment tool for individuals to put their retirement savings into.
- Depending on the person’s employment status, IRA accounts can be of various types and have different tax obligations.
- If you withdraw money from an IRA before age 59.5, you are generally subject to a 10% early withdrawal penalty.
- There are income limitations for contributing to Roth IRAs and for deducting contributions to traditional IRAs.
- The rules regarding maximum contributions and income limits for IRAs change each year.
Understanding the IRA (Individual Retirement Account)
So how does an IRA work? Investments made in IRAs can encompass a range of financial products, including stocks, bonds, ETFs, and mutual funds . A self-directed IRA can be a traditional IRA or a Roth IRA. Self-directed IRAs allow investors to call all the shots and give them access to a broader selection of investments, including real estate, private placements, and tax liens.
Because IRAs are meant for retirement savings , there’s typically a 10% early withdrawal penalty if you take the money out before age 59.5. Depending on the type of IRA you have, you may also have to pay income taxes on its early withdrawal.
Individual taxpayers can set up traditional IRAs and Roth IRAs, while small business owners and self-employed people set up SEP and SIMPLE IRAs. An IRA must be opened with an institution that is authorized by the Internal Revenue Service (IRS) to offer these accounts. Options include banks, brokerage firms, federally insured credit unions, and savings and loan associations. Most individual investors open IRAs with brokers.
Keep in mind that you can only contribute to an IRA with earned income that meets the IRA rules. Income from investments, Social Security benefits, or child support does not count as earned income.
Types of IRA accounts (Individual Retirement Account)
Traditional IRA
As of 2020, individual annual contributions to traditional IRAs cannot exceed $6,000 in most cases . If you’re age 50 or older, you can contribute up to $7,000 per year using catch-up contributions.
For 2020, the IRS left the IRA contribution limits unchanged. However, they changed the income phasing range for deducting contributions to a traditional IRA. The phase-out range changed from $103,000 to $123,000 to $104,000 to $124,000 for married couples and from $64,000 to $74,000 to $65,000 to $75,000 for singles.
Your income and your job’s retirement plan influence the types of IRAs you can open and whether or not your contributions are tax deductible.
Tax deduction
In most cases, contributions to traditional individual accounts are tax deductible . If someone puts $6,000 into an IRA, that person’s taxable income decreases by the amount of the contribution. However, when that person withdraws money from the account during retirement, those withdrawals are taxed at the ordinary income tax rate.
Several key factors determine whether traditional IRA contributions can be deducted. Suppose you are single or filing as head of household and have a retirement plan, such as a 401(k) or 403(b), available at work. So, your Traditional IRA contributions are fully deductible if your Modified Adjusted Gross Income (MAGI) was $64,000 or less in 2019. If you’re married filing jointly, the limit is $103,000 or less. If you earn more, you start losing deductions. Use this chart to determine your place on the list:
Deduction limits if you have a retirement plan at work |
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| Civil status | 2019 MAGI | 2020 MAGI | Deduction |
| SINGLE OR HEAD OF HOUSEHOLD | |||
| $64,000 or less | $65,000 or less | Full deduction up to your contribution level. | |
| More than $64,000 but less than $74,000 | More than $65,000 but less than $75,000 | partial deduction | |
| $74,000 or more | $75,000 or more | No Deduction | |
| MARRIED FILING JOINTLY | |||
| $103,000 or less | $104,000 or less | Full deduction up to your contribution level. | |
| More than $103,000 but less than $123,000 | More than $104,000 but less than $124,000 | partial deduction | |
| More than $123,000 | More than $124,000 | No Deduction | |
| MARRIED FILING SEPARATELY | |||
| Less than $10,000 | Less than $10,000 | partial deduction | |
| More than $10,000 | More than $10,000 | No Deduction | |
Beginning at age 72, traditional individual account holders must begin taking Required Minimum Distributions (RMDs), which are based on account size and life expectancy. Failure to comply with this rule may result in a tax penalty equal to 50% of the amount of the required distribution. In 2019, the Establishment of Every Community for Retirement Enhancement Act of 2019 (SECURE) increased the age requirement for taking RMDs from 70.5 to 72. It also removed the age limit for when a person can contribute to an IRA, which was 70.5.
A person of any age with earned income can now contribute to an IRA.
Roth IRA
Contributions to the Roth IRA are not tax deductible, but qualified or authorized withdrawals are tax-free .
You contribute to a Roth IRA using after-tax dollars, but you don’t face any tax on investment earnings.
When you retire, you can make withdrawals from your account without incurring any income tax. Roth IRAs also do not have RMDs (required minimum distributions). If you don’t need the money, you don’t have to take it out of your account. You can continue to contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.
Contribution limits
Roth IRA contribution limits for 2019 and 2020 are the same as traditional IRAs . The maximum amount is $6,000 for investors under the age of 50. If you’re 50 or older, the limit increases to $7,000, but there’s a catch. There are income limitations for contributing to a Roth IRA.
Beginning in 2019, married tax filers filing jointly can contribute up to the annual contribution limit if their combined MAGI is less than $193,000. The figure for those filing as single or heads of household is $122,000. The total tax cutoff for married couples filing jointly rises to $196,000 in 2020, rising to $124,000 for singles. The details are as follows:
Income limitations for contributing to a ROTH IRA |
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| Civil status | 2019 MAGI | 2020 MAGI | Deduction |
| SINGLE OR HEAD OF HOUSEHOLD | |||
| Less than $122,000 | Less than $124,000 | To the limit | |
| From $122,000 to less than $137,000 | From $124,000 to less than $139,000 | Reduced quantity. | |
| $137,000 or more | $139,000 or more | Nothing | |
| MARRIED FILING JOINTLY OR ELIGIBLE WIDOWED | |||
| Less than $193,000 | Less than $196,000 | To the limit | |
| From $193,000 to less than $203,000 | From $196,000 to less than $206,000 | reduced quantity | |
| $203,000 or more | $206,000 or more | Nothing | |
| MARRIED FILING SEPARATELY | |||
| Less than $10,000 | Less than $10,000 | Reduced Quantity | |
| More than $10,000 | More than $10,000 | Nothing. | |
SEP IRA
Self-employed people, such as independent contractors and small business owners, can create a SEP IRA. The acronym SEP stands for Simplified Employee Pension. A SEP IRA follows the same tax rules for withdrawals as a traditional IRA. For 2019, contributions to the SEP IRA are limited to 25% of compensation or $56,000, whichever is less.
Business owners who establish SEP IRAs for their employees can deduct the contributions. However, company employees cannot contribute to their accounts, and the IRS taxes their withdrawals as income.
SIMPLE IRA
The SIMPLE IRA is also intended for small businesses and the self-employed. The acronym SIMPLE stands for Savings Incentive Match Plan for Employees. It also 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 contributions are tax deductible, bringing the company or employee into a lower tax bracket.
The SIMPLE IRA employee contribution limit for 2019 is $13,000, with a $3,000 catch-up contribution allowed for savers age 50 and older. The contribution limit is raised to $13,500 in 2020, while the recovery limit remains unchanged at $3,000.
IRA account: Compare the different options
Use the chart below to understand and discuss how different IRAs work . Keep in mind that traditional and Roth IRAs require employment income. However, individual taxpayers can open traditional and Roth IRAs on their own. SEP IRAs and SIMPLE IRAs require your employer to set up the plan. You cannot set up a SEP or SIMPLE IRA for yourself unless you are self-employed.
IRA Type Comparison |
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| IRA Type | Employee
Contribution limit (2020) |
Tax-deductible contributions? | Tax-free distributions? | Subject to required minimum distributions beginning at age 70.5? | Who can set it? |
| Traditional | $6,000; $7,000 if she is 50 years old or older. | Yes, but individual deduction amounts are based on income, marital status, and retirement plan coverage through your employer. | No | Yes | Individual taxpayers and couples* |
| Roth | $6,000; $7,000 if she is 50 years old or older. | No | Yes | No | Individual taxpayers and couples*, subject to MAGI limitations |
| SEP | The lesser of the two, 25% of compensation or $57,000 | Business deductions for employee contributions are limited to the lesser of your total contributions or 25% of employee 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 |
| Simple | $13,500; $16,500 if you are age 50 or older. | All contributions made to employee 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 |