Retirement Accounts • August 5th, 2020

What is an IRA? Understanding Individual Retirement Accounts

Stephanie Faris

Key Takeaways
  • IRAs come in two forms: Roth and Traditional, with the primary difference being how each account is taxed.
  • You don’t need an employer retirement plan to set up an IRA and begin contributing money toward retirement.
  • IRAs come with contribution limits and, with Roth IRAs, you can’t participate if your income exceeds a certain amount during the tax year.

If you have an employer, you may already have access to retirement savings options. But if you don’t have those options, or you simply want to do something on your own, an individual retirement account (IRA) can help you save for your golden years. Both traditional or Roth IRAs offer several advantages.

But when you’re asking, “What is an IRA?” there are some differences between 401(k)s and IRAs. Most notable is the contribution limit, which is significantly lower than what’s allowed with a 401(k). But there are also major differences in the two different types of IRAs. Before you go out in search of an IRA, it’s important to know what to expect.

How to Open a Roth IRA

When you’re ready to open an IRA, there’s no shortage of options. You can simply visit your bank and ask for an application, but you’ll get better results if you shop around. You’ll first need to decide whether you want a Roth or Traditional IRA, as well as the funds you want to invest in.

Your IRA account isn’t an investment in itself. You’ll find, as you go through the application process, that you need to choose how you want your investment to be allocated. You’ll be asked to decide the mix of stocks, bonds, mutual funds, ETFs, and more for directing your investment. These choices can make a difference in how well your IRA grows over the years, so it may be worth it to put some time into researching.

Ways to Fund an IRA

Just because you want to know what is a Roth IRA, that doesn’t necessarily mean you have an excess of money to put into one every week. There are a variety of ways you can squeeze a little money out of your budget to build your retirement savings, including:

  • Having a small contribution taken out of each paycheck
  • Contributing any bonuses
  • Automatically contributing business earnings
  • Depositing a portion of your alimony payments
  • Contributing military pay
  • Contributing your tax refund (for Traditional IRA)

You do have more options for contributions if participating in a Traditional IRA. The Roth IRA definition means that you’re limited in what types of funds you can put into it.

What Can You Contribute to a Roth IRA?

Pay close attention to Roth IRA rules when it comes to contributions. The IRS only allows earned income to a Roth IRA since you won’t be taxed on the funds when taken out. With a Traditional IRA, you pay taxes when you take the money out. A Roth IRA has you contributing after-tax funds, which means the IRS assumes at retirement that every dollar in that account was put in after you paid taxes on it.

Because of that benefit, the IRS has stricter guidelines for contributions into a Roth IRA account. You can’t, for instance, contribute the Christmas cash you receive from your grandmother because that means you’d never be paying taxes on that money. The question, before putting money into a Roth IRA, is whether you’ve paid taxes to the IRS on those funds. If you want to contribute gifts and other untaxed fund sources, consider a Traditional IRA instead.

Who's Eligible for a Roth IRA?

If you want to open an IRA, you’ll need to have taxable income and be under the age of 70½. That’s all you’ll need to open a Traditional IRA. Things get a little more complicated if you’re interested in setting up a Roth IRA.

Being eligible is only the first step with a Roth IRA. Your income will need to fall below the limit for the year to be able to contribute. Below are those income ceilings.

Filing StatusAdjusted Gross IncomeLimit on Contributions (Under Age 50)Limit on Contributions (Age 50+)
Married Filing JointlyLess than $196,000$6,000$7,000
$196,000 to $205,999Partial contribution allowedPartial contribution allowed
$206,000 or moreIneligible to contributeIneligible to contribute
Married Filing SeparatelyLess than $10,000Partial contribution allowedPartial contribution allowed
$10,000 or moreIneligible to contributeIneligible to contribute
SingleLess than $124,000$6,000$7,000
$124,000 to $138,999Partial contribution allowedPartial contribution allowed
$139,000 or moreIneligible to contributeIneligible to contribute
Tip: The above limits apply specifically to direct Roth IRA contributions. Some high-earning taxpayers get around the limit by contributing to a Traditional IRA and converting the funds to a Roth IRA later.

Spousal IRA Contributions

Not everyone earns income. Although Roth IRA contributions are limited to earned income, there’s a way around it for married couples. If one spouse doesn’t work outside the home, you can take advantage of something known as a Spousal IRA.

An important part of determining what is an IRA account, though, is understanding contribution limits. With a Spousal IRA, you’ll need to look at your taxable income on your joint tax return. Together, you and your spouse can only contribute up to that amount. Publication 590-A has a formula you can use to make sure you stay on the safe side of the limit.

Withdrawal Considerations

One of the best things about learning how a Roth IRA works is discovering that, in certain instances, you can take the money out penalty-free. But you’ll need to follow certain qualifications to avoid paying taxes and penalties on the withdrawal.

Qualified Distributions

If you have a Roth account, when you’re 59½, you may be able to take money out without paying taxes or penalties on it. You’ll need to limit your withdrawal to the amount you’ve put into the account and have at least five years of contributions since initially opening the IRA. If you aren’t 59½, you may be able to take a qualified distribution if you’re disabled or use the funds toward a qualifying first home purchase.

Although you will skip paying taxes on the distribution, you’ll still lose money on the deal. The funds you have in your IRA have the potential for compounding growth, and you won’t be able to withdraw those. You can only withdraw the funds you’ve contributed.

A Traditional IRA does not allow qualified distributions. You’ll pay taxes and a 10 percent penalty on any amount you take out unless you meet some of the qualifications listed below.

Non-Qualified Distributions

With a non-qualified distribution, you don’t get to skip Roth IRA taxes. In fact, you’ll likely pay income taxes plus a 10 percent penalty on the amount you withdraw. As the name implies, this type of distribution is non-qualified because you didn’t meet the qualifications, listed above, for taking the money out tax-free.

But there are some instances when you can withdraw both your Traditional and Roth contributions without paying taxes or penalties. If your unreimbursed medical expenses exceed 10 percent of your adjusted gross income for the year, you can take IRA funds out to pay for them. You can also use the funds to pay for higher education expenses or up to $5,000 in adoption or childbirth expenses. If you lose your job, you can withdraw Roth IRA funds to pay for medical insurance.

Roth IRA vs. Traditional IRA

Once you’ve decided an IRA is the retirement savings option for you, it’s time to decide whether you’ll make a Traditional or Roth IRA investment. The answer depends on your circumstances.

If you’re a high earner, a Traditional IRA will be your only choice, as you learned while discovering how an IRA works. Depending on an individual’s circumstances, traditional IRAs can be a good retirement savings vehicle. Many people will be in a lower tax bracket when they retire, so they’ll pay less on the money than they would pay while they’re still working.

Still, you may simply want to reduce your tax burden for your future self. Roth IRAs let you take the money out tax-free when you retire. They’re also a good idea if you want the option to take tax-free distributions once you’re 59½. Roth IRAs are also a good idea if you’re trying to diversify your portfolio, putting your money into a combination of taxable and tax-free accounts.

Tip:

Final Thoughts

Now that you understand what is a Roth IRA account, as well as the differences between it and a Traditional IRA, it’s time to decide if you want to open one. We recommend sitting down with a Certified Financial Planner® to map out a plan for your retirement. Then you’ll be able to determine what savings you’ll need to make sure you’re well taken care of after you stop working.

Author

Stephanie Faris

Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a writer for a credit card processing service and has written about finance for numerous marketing firms and entrepreneurs. Her work has appeared on Money Under 30, The Motley Fool, MoneyGeek, E-commerce Insiders, and GoBankingRates.