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What is Individual Retirement Account (IRA) and How it Works?

Last Updated : 20 Dec, 2023
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Individual Retirement Account or IRA is a type of savings account in the United States that would reap benefits after retirement as it will act as a pension, provided by financial institutions. It is a long-term savings account where an individual can enjoy certain tax advantages. This IRA is specifically created for the self-employed individual who cannot avail of the 401(k) retirement account provided by employers. One can open an IRA savings account via any financial institution, a bank, an online brokerage, an investment company, or a personal broker.

Geeky Takeaways:

  • Meaning: IRA is a retirement pension plan in the United States that offers tax benefits, investment flexibility, and provision for long-term growth.
  • Account Types: Usually four types are there, Traditional IRAs, Roth IRAs, SIMPLE IRAs, and SEP IRAs.
  • Amount Limitation: Traditional IRAs and Roth IRAs, both have limitations on the annual income, leading to restricting the amount of tax avoidance.
  • Withdrawal: Before the age of 59 and a half years, one can withdraw money from an IRA only after incurring a hefty tax penalty of around 10% of the amount to be withdrawn.
  • RMD Age: The age of availing the RMD (required minimum distribution) has been raised by 1 year from 71 to 73 as of 1st January 2023.

How does an IRA Work?

1. Any individual who has a regular income is eligible to avail of this IRA facility. Even employees who are liable for a 401(k) plan can contribute to an IRA. The only limitation is the cap on the yearly contribution to these retirement accounts.

2. While availing of an IRA facility, one has the liberty to invest their money either in the market or in an interest-paying account. The investment can be carried on multiple financial products like stocks, mutual funds, bonds, and ETFs (exchange-traded funds).

3. An individual earning a living is eligible to contribute to an IRA. Social security benefits, interest, dividends, and savings for child support are not accounted for as earnings or income.

4. Self-Directed IRAs (SDIRAs) are there that offer investors to make their own investment decisions. A wider range of investments including real estate and commodities are offered by SDIRAs.

5. Among the different IRAs, traditional and Roth IRAs can be opened by individual taxpayers. While SEP and SIMPLE IRAs can be opened by small venture owners or self-employed individuals.

6. IRAs should be opened with those financial institutions which have received IRS (Internal Revenue Service) approval. Hence, the options to open an IRA include banks, brokerage firms, savings and loan associations, and federally insured credit unions.

7. As an IRA is an investment plan for future retirement, early withdrawal before the age of 59 and a half years incurs a penalty of 10% of the total amount withdrawn. However, there are few exceptions in case of withdrawing an amount for educational purposes or first-time purchasing houses.

8. In traditional IRAs, a certain tax will be levied on early withdrawal. On the other hand, the Roth IRA is funded with a post-tax amount, hence no extra taxes are levied when the amount is withdrawn.

Why Invest in an IRA?

Many financial experts believe that after retirement, an individual requires around 85% of their pre-retirement income. Therefore, it is suggested to open an IRA apart from the 401(k) plan. This would help the individual live a stress-free life post-retirement. In addition to this, there are certain benefits that IRA brings in and offers reasons for investment.

1. Tax Benefits: IRAs provide tax benefits that can help an individual with retirement savings. While from a Roth IRA, eligible withdrawals are tax-free, investments made to traditional IRAs may be taxable.

2. Investment Options: A range of investing opportunities is provided by IRAs. It consists of mutual funds, equities, and bonds. This allows an investor to diversify their portfolio and maximise the potential returns.

3. Flexibility: There is flexibility in IRAs as it allows an individual to make withdrawals and deposits at any time. This provides the flexibility to adjust the retirement savings plan as required.

4. Security: The FDIC (Federal Deposit Insurance Corporation) has insured the IRAs providing safety and security.

5. Portability: IRAs can be easily transferred to different places, thus due to their portability, one should invest in IRAs.

6. Estate Planning: In IRAs, one can designate beneficiaries or nominee where the money or wealth can be distributed to their listed beneficiaries. IRAs ensure an individual can plan their estates accordingly.

Thus, the above points are enough to prove the benefits of investing in an Individual Retirement Account (in the United States) and the National Pension Scheme (in India).

Types of IRAs

IRAs can be categorised into four different groups, Traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.

1. Traditional IRA: This type of savings account is usually tax-deductible, i.e., if an individual deposits ₹10,000 into an IRA, then their taxable income for that year would be reduced by ₹10,000. Traditional IRAs allow money to grow by deferring the tax. At the time of withdrawal after retirement, regular income tax is levied for that year.

2. Roth IRA: Roth IRAs are a type of savings account where the contributions will be taxable but the future withdrawals will be free of tax. This implies an individual depositing in a Roth IRA using a post-tax fund needs to pay zero tax for all the income generated from that investment. Further, there are no RMDs (required minimum distributions), i.e., if one does not need money, he/she need not take it out of the account. One can contribute to a Roth IRA as long as one has a regular income and the age doesn’t matter.

3. SEP (Simplified Employee Pension) IRA: This type of pension plan can be used by self-employed individuals for example small business owners, independent contractors, and freelancers. SEP IRA is set up by the business owners for their employees and they can deduct the contributions made on behalf of the employees. The employees are not allowed to contribute to their accounts and the Internal Revenue Service (IRS) taxes their withdrawals considering them as income.

SEP IRA corresponds to the same tax rules for withdrawals as the traditional IRA. This IRA contribution for the year 2023 has been limited to 25% of compensation or $66,000, whichever is lower. The maximum allowed contribution is capped at $69,000 for the year 2024.

4. SIMPLE (Savings Incentive Match Plan for Employees) IRA: This SIMPLE IRA is also designed for self-employed individuals and small business owners. Tax rules for withdrawals are the same as traditional IRAs. The only difference between SEP and SIMPLE IRAs is that here employees are allowed to contribute to their accounts with the employer. The employer or employees are pushed into the lower tax bracket as the contributions made are tax deductible.

In 2023, employee contribution is limited to $15,500 and the catch-up limit (for workers who are more than 50 yrs) is $3,500. For the year 2024, the contribution limit has been increased to $16,000 while the catch-up limit will be constant at $3,500.

5. Rollover IRA: A Rollover IRA is set up when funds from a retirement plan that was sponsored by the previous employer are rolled into a new IRA plan. The owner of the account need not pay any taxes or penalties. This IRA allows the owner to run this savings account along with taking advantage of other investment opportunities that have lower fees. It has the flexibility of combining multiple retirement savings accounts into a single account. Rollover IRA can transfer accounts from 401(k) or 403(b) to a retirement savings account.

IRA Contribution Limits 2023-2024

I. Traditional IRA

For the year 2023, the contribution limit is set to $6,500 and the maximum catch-up contribution (for individuals of more than 50 years of age) is $1,000. The yearly contribution limit in the traditional IRA for 2024 is capped at $7,000 keeping the catch-up limit constant at $1,000.

For an individual who does not have a 401(k) or any other employer-sponsored retirement plan, traditional IRAs are completely deductible. However, if the individual or his/her spouse has a company-sponsored retirement plan, then their modified adjusted gross income (MAGI) would determine the amount that can be deducted from their traditional IRA. The below chart would help in determining the deductions for the years 2023 and 2024.

Filing Status 2023 MAGI 2024 MAGI Deductions
Single Taxpayers or Head of Household
  $73,000 or less $77,000 or less Full deduction up to the level of contribution
  More than $73,000 but less than $83,000 More than $77,000 but less than $87,000 Partially deductible
  $83,000 or more $87,000 or more Zero deduction
Married Filing Jointly
  $116,000 or less $123,000 or less Full deduction up to the level of contribution
  More than $116,000 but less than $136,000 More than $123,000 but less than $143,000 Partially deductible
  $136,000 or more $143,000 or more Zero deduction
Married Filing Separately
  Less than $10,000 Less than $10,000 Partially deductible
  $10,000 or more $10,000 or more Zero deduction
Married and only spouses have a retirement plan at work
  $218,000 or less $230,000 or less Full deduction up to the level of contribution
  More than $218,000 but less than $228,000 More than $230,000 but less than $240,000 Partially deductible
  $228,000 or more $240,000 or more Zero deduction

II. Roth IRA

The maximum annual contributions for 2023 and 2024 in Roth IRAs are similar to traditional IRAs. But, there are limitations in income for contributing to a Roth IRA. The below chart depicts the income limitations for the contributions.

Filing Status 2023 MAGI 2024 MAGI Contributions
Single taxpayers or Heads of Household
  < $138,000 < $146,000 Up to the limit
  > $138,000 and < $153,000 > $146,000 and < $161,000 Reduced amount
  $153,000 or more $161,000 or more Zero limit
Married Filing Jointly or Qualifying Widow(er)
  < $218,000 < $230,000 Up to the limit
  > $218,000 and < $228,000 > $230,000 and < $240,000 Reduced amount
  $228,000 or more $240,000 or more Zero limit
Married Filing Separately
  < $10,000 < $10,000 Reduced amount
  $10,000 or more $10,000 or more Zero limit

What are Required Minimum Distributions (RMDs)?

Required Minimum Distributions (RMDs) are the minimum withdrawal amount that traditional IRA and 401(k) account holders must take annually after reaching a certain age. This age has been rising after certain revisions and as of 1st January 2023, the age of withdrawal has been increased to 73.

These withdrawals are taxable and the IRS (Internal Revenue Service) monitors it. Based on the account balance and life expectancy of an individual, the amount to be withdrawn is calculated by the IRS. A severe tax penalty is levied if the minimum amount is not withdrawn. A penalty of 25% of the balance of the account is imposed in 2023. Although the penalty is half of the previous year, the losses incurred are quite expensive.

How to Open an IRA?

An individual can open an IRA at most banks, online brokers, credit unions, or any other financial services providers. Some examples of brokers providing IRAs are- Fidelity, Charles Schwab, and Merrill Edge. To open an IRA the following easy steps would help,

1. Choose Between an Online Broker or Robo-Advisor: Selecting your personal preference for investments is an important step before opening an IRA. Making own personal investments via an online broker or choosing a digital investment platform for making decisions is an individual’s choice. Online brokers such as Merrill Edge, Fidelity, or Charles Schwab provide a platter of investments including Roth IRA, traditional IRA, or rollover IRA. It depends on the individual whichever medium one chooses for opening an IRA. Wealthfront and Betterment are standalone robo-advisors for IRA.

2. Decide Where to Open an IRA: After selecting the platform for investment whether doing it on its own or taking the help of robots, the next step is to identify under which financial service provider the IRA will be set up. Before opening an IRA, one should identify the yearly IRA management fees, minimum investment amount, available investment types, customer service facility, and customer reviews.

3. Choose an IRA to Invest in: The next step is to choose the type of IRA for investing considering the tax and personal financial situation. All the rules and limitations must be studied to choose the best fit IRA.

4. Opening an Account: Opening an IRA requires all the personal and financial documents for identifying an individual. Every website contains an ‘open an account’ option which needs to be clicked to open an IRA. After selecting, the required personal and financial details need to be filled in.

5. Fund that Account: After opening the IRA, the individual needs to fund the account. This can be done by linking an existing financial account with the new IRA. On the bank’s website, an external transfer tab will be available where all the required information must be entered about the newly opened IRA.

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