What is an IRA?

One account you can use to save for the long term is the Individual Retirement Arrangement, or IRA. This savings vehicle optimizes investment growth by managing when taxes are paid.

An IRA is especially useful if your employer doesn’t sponsor its own retirement account. It can help give your retirement investments a boost from similar tax advantages.

Still, for all their benefits, there are things you should know before you open an IRA. First off, there are different types of IRAs from which to choose. Also, IRAs are not the right savings vehicle for every situation.

It’s important to understand its characteristics – the advantages and limitations – so you plan properly for your current situation and future needs. This article explains those characteristics so you can decide what’s right for you.

What is an IRA?

An IRA is an Individual Retirement Arrangement.^[1] This type of investment account has certain tax advantages that help you save for the future. In return for those advantages, IRAs also come with some restrictions. Those include limits on how much you can contribute, how you can invest money, and when you are able to draw money out of the IRA.

An IRA must be set up with a trustee. The trustee has custody of your IRA’s assets and administers the account according to IRS regulations. Banks, credit unions, brokerage firms and other qualified financial institutions can act as a trustee.

The chief tax advantage of an IRA is that, while your money is invested in the account, you don’t have to pay taxes on the income it earns or on investment gains on securities bought and sold in the account.

You will have to pay tax on IRA money either before you put it into the account or when you take it out. However, not having to pay taxes on investment earnings while the money is in the account helps it grow by compounding more quickly.

Here’s the catch, though: In most cases, you will pay a 10% penalty if you take money out of an IRA before you reach age 59 ½.^[2] That’s on top of any ordinary income tax due. For people who are many years away from reaching that age, this makes putting money into an IRA a long-term decision.

Main types of IRAs: Traditional and Roth

As noted previously, you have to pay ordinary income taxes either before your money goes into an IRA or when it comes out. You get to choose which, and that choice is the defining difference between the two major types of IRAs: traditional and Roth.^[3]

Traditional IRAs

Traditional IRAs are called that because they were the first types of IRAs created back in the 1970s. Traditional IRAs allow you to deduct the money you contribute to them and put off paying taxes on it until you take the money out.

The amount of the IRA contribution you can deduct each year is limited.^[4] For 2023, the limits are $6,500 if you are below age 50, and $7,500 if you are age 50 or above. Those limits are doubled for married couples filing jointly.

The size of an IRA contribution you can deduct is also limited by your income. These income limits vary year by year, so you need to check each year when planning your IRA contribution.

If you or your spouse participate in a retirement plan at work, your IRA deductions may be further limited, depending on your income.

When it comes to taking money out of a traditional IRA, as long as you are at least 59 ½ years old, withdrawals from a traditional IRA will be treated as ordinary income and taxed at whatever income tax rate applies to you.

Another important characteristic of traditional IRAs is that you have to start taking money out each year after you reach age 72. If you live longer than that, you will have to pay some taxes on your IRA money eventually.

These mandatory withdrawals are called required minimum distributions (RMDs). The amount of the RMD varies each year - it is determined according to an IRS formula based on your age and applied to the current value of your IRA.

Roth IRAs

While traditional IRAs give you a tax deduction when you contribute money to the plan, Roth IRAs do not. Instead, they allow you to receive distributions from the account tax-free, as long as you are 59 ½ or older.

The difference in tax treatment boils down to that, with a Roth IRA, you pay your taxes up front and then get tax-free distributions later on. In contrast, a traditional IRA gives you the tax break up front, but you have to pay taxes on distributions later on.

Another way Roth IRAs differ from traditional IRAs is with respect to RMDs. While traditional IRAs require you to start taking money out after you reach age 72, Roth IRAs do not.

As with traditional IRAs, the amount you can contribute to a Roth each year is limited. For 2023, the limits are $6,500 if you are younger than 50, and $7,500 if you are older. Those amounts are doubled for married couples filing jointly.

IRA contributions are also limited according to your income. These limits vary from year to year, so you have to check back each year when planning your IRA contributions.

Other IRAs

While traditional and Roth are the major categories of IRAs, there are some other specific varieties of these retirement plans:

• Payroll deduction IRAs. These are set up by some employers. While the employer does not make contributions on your behalf, they facilitate your contributions through payroll deduction. You can choose between a traditional or Roth IRA in these programs.
• Simplified Employee Pension Plan (SEP IRA). In a SEP IRA, your employer makes contributions on your behalf into an IRA account. The employee does not get to deduct that contribution, but it is not included in taxable compensation either. However, as with a traditional IRA, you will be subject to taxation when you take distributions from the plan.
• Savings Incentive Match Plan for Employees (SIMPLE IRA). This is a plan your employer administers on your behalf. It allows you to choose to make contributions out of your salary into an IRA, and then the employer makes matching contributions to your account. You cannot deduct your contributions, but they are not included in your taxable compensation so it is essentially pre-tax money. As with a traditional IRA, taxation occurs on the back end when you take money out of the plan.
• IRA rollovers. An IRA rollover is typically created when you leave a retirement plan but don’t want to lose your tax advantages. The money may be coming from a 401(k) or other employee-sponsored plan, or from another IRA. As long as the money is deposited in an IRA within 60 days, it is not subject to tax consequences.^[5]

How to decide between traditional and Roth IRAs

While IRAs have a few different variations, the important distinction is between traditional and Roth IRAs.

So how do you decide which is right for your needs? There are two things to focus on when making your decision:

• The timing of taxes
• Distribution requirements

Timing of taxes

With a traditional IRA, you get a tax deduction on your contributions and don’t have to pay taxes until you withdraw the money. With a Roth IRA, you take the tax hit up front and get to enjoy tax-free distributions later.

You can try to maximize this advantage by judging whether your tax rate is likely to be higher now or once you retire. A classic example is that people early in their careers may have limited earnings and low taxes. It may be better for them to take the tax hit now while their tax rate is low. So, in that situation, the up-front tax payment of a Roth IRA might be the way to go.

In contrast, someone in their peak earning years may be in a high tax bracket. That could fall off once they retire. Someone in that situation might be better off delaying taxation until after they retire.

Distribution requirements 

Required minimum distributions force traditional IRA owners to start taking money out of their accounts after they reach age 72. That subjects those distributions to ordinary income taxes.

On the other hand, Roth IRA owners paid taxes on their money before it went into the account. Because of that, there are no RMDs on Roth accounts.

This means that Roth IRA owners can continue to enjoy tax-free growth for as long as their money is in the account. For people who have other money to live on in retirement, or low retirement living costs relative to the size of their retirement savings, avoiding RMDs with a Roth account can help them prolong their tax savings.

This might not only help preserve retirement resources longer but may also keep more of the IRA available to leave as a legacy when the account holder dies.

Drawing money out of an IRA

Before you put money into an IRA, you should think carefully about how you’re going to need to take money out of the account. That’s because there are rules governing distributions from IRAs both before and after you reach retirement age.

Pre-retirement withdrawals

As a general rule, withdrawals before you reach age 59 ½ will be subject to a 10% tax penalty, in addition to ordinary income tax consequences.

However, there are exceptions to that penalty under certain circumstances.^[6] Here are some notable examples:

• Qualified first-time homebuyers can take up to $10,000 out of an IRA to put toward their purchase.
• Certain unreimbursed medical expenses or health insurance paid while unemployed
• Qualified higher education expenses

Note that even distributions that are exempt from the 10% tax penalty may be subject to ordinary income taxes if they come from a traditional IRA.

Post-retirement withdrawals

Once you reach age 59 ½, you are free to take as much money out of your IRA as you want. However, if it is a traditional IRA, you will be subject to ordinary income taxes on distributions from the account. The tax effect is important to remember when planning how much income your IRA will provide you in retirement.

As noted in a previous section above, RMDs have a big impact on how you take money out of an IRA. In a traditional IRA, you must start taking RMDs after you reach age 72. This means you have to pay taxes on those distributions, and that money can no longer grow tax-free.

However, it’s important to note that this does not necessarily mean you should spend the full amount of those RMDs. There’s no telling how long you’ll live and what your future needs will be, so it may be wise (to the extent possible) to preserve some of the money you’ve drawn out even after the tax advantage is over.

Advantages and disadvantages of IRAs

When deciding whether to contribute to an IRA, you have to decide first whether you want to live with the restrictions of IRAs in general, and then choose whether a traditional or a Roth IRA is better for you.

To help with these decisions, the tables below summarize the advantages and disadvantages of each type of IRA.

Traditional IRAs: Pros and cons

Roth IRAs: Pros and cons

Thinking ahead when making IRA decisions

The penalty on early withdrawals from an IRA makes contributing money to one a long-term commitment unless you are close to or above age 59 ½.

That makes it important to think ahead when making decisions about an IRA. Some things to consider:

• Other savings needs: If you have other financial goals you want to act on between now and reaching age 59 ½, you may want to keep some savings outside of an IRA. Note that even the $10,000 exemption from the 10% early distribution penalty for first-time home buyers wouldn’t even cover the down payment on most home purchases today.
• Other investment opportunities: If you want to pursue investment opportunities that would not be permitted within an IRA, you may want to keep some money available outside of an IRA. While those investments would not have the tax advantages of an IRA, you may deem them attractive if you expect their after-tax return on investment to be superior to what you could earn on investments within an IRA.
• Your tax situation: While future tax rates are impossible to predict, whether your tax bracket today is nearer the higher or lower end of the spectrum may be a reasonable basis for choosing between a traditional and a Roth IRA.

With the right planning, the tax advantages of an IRA can help you save for retirement more cost effectively.

Lifetime financial security: Start your subscription

We hope you enjoyed this article.

Something’s happening in the world of personal finance. Frugal Gnome is changing how people learn to build wealth. They’re doing it themselves – with a new sense of confidence because they know what’s going on with their money, how quickly they will reach their goals, and without wasting time going down the rabbit hole known as search.

You can do it too. Join us with a special offer.

For a limited time, a $0.99 monthly subscription gets you unlimited access to three pathways on the Frugal Gnome site, including all the articles and tools you need to lay a great financial foundation so you can build wealth. Please join us on the journey to build fantastic finances. We’re rooting for you!

LET'S GET STARTED

Sources:

1. Individual Retirement Arrangements (IRAs)
   IRS.gov | Accessed: 01-30-25
2. IRA FAQs
   IRS.gov | Accessed: 01-30-25
3. Traditional and Roth IRAs
   IRS.gov | Accessed: 01-30-25
4. IRA Deduction Limits
   IRS.gov | Accessed: 01-30-25
5. Rollovers of Retirement Plan and IRA Distributions
   IRS.gov | Accessed: 01-30-25
6. Retirement Topics - Exceptions to Tax on Early Distributions
   IRS.gov | Accessed: 01-30-25