Individual Retirement Accounts (IRA)

An individual retirement account (IRA), sometimes known as an individual retirement arrangement, is a type of investment account used to save for retirement. When one deposits funds into an IRA, those funds can be invested in a number of different securities, such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs). This typically allows one’s retirement fund to increase in value over time. Unlike employer-sponsored retirement accounts, IRAs are typically opened and managed by individuals and serve as an additional means of saving for retirement, beyond the options offered by one’s employer. IRAs are subject to yearly contribution limits, and one must have received taxable compensation in order to make contributions. In addition to their important role in helping numerous Americans prepare for retirement, IRAs offer a host of tax benefits that may reduce an account holder’s taxable income or the taxes paid on account disbursements.

Background

Saving for retirement is an issue of great importance in the United States in the early twenty-first century, as large portions of the population grow older and federal programs that benefit retirees, such as Social Security, face numerous political and economic challenges. Many companies offer retirement plans, such as 401(k) plans, to their employees, but such plans have federally mandated annual contribution limits that may at times not meet employees’ savings needs. Other companies do not offer retirement plans at all, thus requiring employees who seek to save for retirement to establish their own retirement accounts. In addition to saving for retirement, some individuals may also seek to reduce their taxable income or withdraw tax-free earnings while in retirement. Different types of IRAs offer different types of tax benefits, and an individual may choose which type of IRA to open based on his or her tax needs.

Traditional IRAs first became available to the public in 1975, after being introduced the previous year by the Employee Retirement Income Security Act (ERISA). The rules associated with traditional IRAs have evolved significantly over the decades. For example, they were initially limited only to workers who did not have pension plans but later became available to all adults under the age of seventy and one-half who have received taxable compensation. The Roth IRA, a specific kind of IRA that allows for income-tax-free withdrawals, was introduced with the passage of the Taxpayer Relief Act of 1997. In addition to the two main types of IRAs, the federal government has also created additional types, including the simplified employee pension (SEP) IRA, introduced via the Revenue Act of 1978, and the savings incentive match plan for employees (SIMPLE) IRA, introduced via the Small Business Job Protection Act in 1996. Such IRAs are typically used by small businesses as alternatives to more complex retirement plans but may also be used by self-employed individuals without any employees.

By the early twenty-first century, IRAs were one of the most popular types of retirement accounts in the United States, housing trillions of dollars in retirement savings. According to a 2023 report by the Investment Company Institute, around 42 percent of US households, or 55.5 million households, reported owning an IRA. Such statistics demonstrate the enduring popularity of IRAs among American workers more than three decades after their introduction.

Overview

When opening an IRA, one must determine which type of account best meets one’s retirement needs. Among the factors to consider are whether one is employed by a company or self-employed and whether one expects to be in a higher income-tax bracket in the present or at retirement age. As accounts that are typically opened through brokerage firms, IRAs may be subject to a variety of service fees or other charges, which can significantly decrease one’s total account accumulation. Account holders must also typically pay commissions when they buy or sell securities within their IRAs. Because of this, it is important to research multiple firms and compare the various fees charged when planning to open an IRA.

The traditional IRA is the oldest and least specialized of the various types of individual retirement accounts. This type of IRA is open to any individual under the age of seventy and one-half who has received taxable compensation or whose spouse has received taxable compensation. By 2024, most individuals under the age of fifty were eligible to contribute $7,000 to their IRAs, while those whose taxable compensation was less than the IRS limit could only contribute up to their taxable compensation. An individual’s annual contribution could be split among multiple IRAs, but the total contribution could not exceed his or her limit. As they were closer to retirement age, individuals who were fifty or older could contribute up to $8,000 each year. To avoid paying a penalty, account holders must refrain from withdrawing funds from the IRA until he or she reaches the age of fifty-nine and one-half, unless the withdrawn funds are used to pay for certain educational, medical, or home expenses.

In some cases, contributions made to a traditional IRA are tax deductible, meaning that the account holder may deduct the amount of funds deposited from his or her taxable income, thus reducing the amount of taxes owed for that year. Whether one’s contributions are fully or partially deductible depends on a number of factors, including income limitations. For the 2024 tax year, people filing taxes as single or head of household were eligible to deduct the full amount of their contributions if they were covered by a retirement plan at their jobs and their modified adjusted gross income was no more than $77,000. Married couples filing jointly who were covered by an employer-sponsored plan could deduct their full contributions as long as their combined income did not exceed $123,000. For individuals not covered by an employer-sponsored retirement plan and whose spouse was likewise not covered, IRA contributions were fully deductible regardless of income. An individual who holds a traditional IRA must begin to take minimum distributions from the account by April 1 following the year he or she turns seventy and one-half. Those distributions and any other withdrawals are subject to federal income tax.

The Roth IRA is an alternative to the traditional IRA and has a variety of different tax implications. Roth IRAs are open to all individuals, regardless of age, who have received taxable compensation but whose income does not exceed a certain amount, based on tax-filing status. As with traditional IRAs, yearly contributions were limited to $7,000 for individuals under fifty and $8,000 for those fifty and older in 2024. An account holder is not required to take minimum distributions at any point and may choose to withdraw contributions early if necessary, although he or she may be required to pay a tax penalty on any early withdrawal. Exceptions to this penalty rule apply to individuals with certain disabilities as well as some first-time home buyers.

Because Roth IRA contributions are not tax deductible and therefore do not decrease one’s tax burden at the time they are deposited, account holders instead have the opportunity to pay little or no tax on withdrawals. Individuals over the age of fifty-nine and one-half may withdraw distributions, consisting of both their original contributions and their investment earnings, without paying income taxes on those funds. The Roth IRA is thus beneficial for individuals who expect to be in a higher income-tax bracket when they reach retirement.

In addition to the traditional and Roth IRAs, the federal government has also introduced the SEP and SIMPLE IRAs, which are used by both self-employed individuals and businesses. Unlike traditional and Roth IRAs, SEP IRAs have significantly higher contribution limits. In 2024, a self-employed individual who opened an SEP IRA was permitted to make a yearly tax-deductible contribution of up to 25 percent of their total compensation, capped at $69,000. SEP IRAs follow many of the same rules as traditional IRAs with regard to required minimum distributions, penalties, and the payment of income taxes upon withdrawal.

A self-employed individual enrolled in a SIMPLE IRA was permitted to contribute up to $16,000 for the year in 2024. Those over the age of fifty were also eligible to make an additional contribution, known as a catch-up contribution, of up to $3,500. Much like SEP IRAs, SIMPLE IRAs generally adhere to the withdrawal, distribution, and tax requirements of traditional IRAs. SIMPLE IRAs are particularly useful for self-employed individuals who hope to transform their business into a multiple-employee company in the future.

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