What is an IRA?
An IRA is a type of tax-advantaged investment account. There are different types of IRAs with slightly different rules, which we’ll cover in more detail below. But all IRAs have one thing in common: you won’t pay capital gains taxes on any profits you earn from investments inside your account.
That means your money can grow tax-free inside your IRA over years or even decades.
You can open an IRA even if you have another retirement account, like a 401(k), or even if you don’t have any other investing account. However, note that there are limits to how much you can contribute to an IRA each year and rules around when you can withdraw your money without tax penalties.
What Can You Invest in with an IRA?
One of the great things about an IRA is that it offers extremely flexible investment options.
Many investors open an IRA through a stock broker. In that case, you can invest in any assets your broker offers. You can often invest in traditional assets like stocks and bonds, new assets like cryptocurrency, and inflation-resistant assets like gold.
It’s also possible to create a self-directed IRA Limited Liability Corporation (LLC) to invest in less conventional assets. With an IRA LLC, you can invest in real estate, buy a company, or purchase fine artworks through your IRA.
Advantages of Opening an IRA
There are numerous benefits to opening an IRA—here are the top five reasons for you to consider opening an IRA:
1. Tax Savings
The reason many retirement investors choose to open an IRA is to reduce their tax bill. Any capital gains earned from buying and selling assets in an IRA are tax-free.
That can translate to significant savings over the course of your investing career. Depending on your income and investment style, capital gains taxes normally eat up 10-37% of your investment profits.
It’s important to note that IRAs aren’t completely tax-free. You’ll still pay taxes on the money you contribute to an IRA before you start investing it or on withdrawals from your IRA in retirement.
2. Compound Growth
Compound growth is one of the main reasons why investing is such a powerful way to build wealth for retirement. Investors can return their profits from a successful investment into the market. So, the amount you have invested increases over time and you can earn greater profits in the future as a result.
Your potential for compound growth is supercharged in an IRA thanks to the tax advantages of this type of account. Capital gains that would normally be set aside for taxes can instead be utilized for new investments. So, with every profitable investment, you’re able to put an additional 10-37% of your earnings to work for you compared to a taxable investing account.
3. Increased Retirement Contributions
A problem many high-income investors face is that they reach the maximum contribution limit for their 401(k) each year. In 2023, the 401(k) contribution limit is $22,500, or $30,000 if you are at least 50 years old.
However, you can contribute to both a 401(k) and an IRA in the same year. If you have both types of accounts, you effectively have a higher limit for retirement account contributions.
The IRA contribution limit for 2023 is $6,500, or $7,500 if you are at least 50 years old. So, an investor under 50 with both a 401(k) and an IRA could contribute up to $29,000 to tax-advantaged investing accounts in a single year.
4. Flexible Investment Options
We talked above about how IRAs enable you to invest in everything from stocks and bonds to cryptocurrencies and real estate. It’s worth contrasting this flexibility with other types of retirement accounts, such as 401(k)s.
With a 401(k), you’re limited to investing in a small selection of assets that your employer and broker have agreed to. Usually, this is a small list of ETFs and mutual funds. Most 401(k) plans don’t allow you to invest in individual stocks.
So, even if you aren’t contributing the maximum to your 401(k), it can be a good idea to invest in an IRA as well since it enables you to diversify your retirement portfolio. Additionally, if your employer matches contributions to your 401(k), it’s usually best to maximize your contributions to that account.
5. Low Fees
Many brokerages now offer fee-free IRAs. You won’t pay any fees to open or maintain an account. You also won’t pay commissions when buying most stocks, bonds, and ETFs.
All the money you save on fees can be put towards investments instead. Like saving money on taxes, this contributes to enhancing compound growth in your retirement account.
Drawbacks of an IRA
While IRAs can be very beneficial for many retirement investors, it’s important to understand their rules and limits. Here are a couple of factors that you should carefully consider before investing in an IRA:
Contribution Limits
There are strict limits on how much money you can contribute to an IRA each year. In 2023, the limit is $6,500. If you’re over 50 years old, you can contribute an additional $1,000 per year as a catch-up contribution (for a total limit of $7,500).
You can have multiple IRAs, but the contribution limit is cumulative. That is, you can contribute at most $6,500 across all of your accounts, not $6,500 per account. On the plus side, how much you contribute to a 401(k) or another retirement plan does not impact your ability to contribute to an IRA.
Withdrawal Rules
IRAs also have strict rules around withdrawing funds. The rules vary slightly depending on the type of IRA you open, but there are some common themes.
First, you’ll face tax penalties in most circumstances if you withdraw funds from an IRA before age 59 ½. The main exception is that you’re allowed to withdraw up to $10,000 for a first-time home purchase. There are also exceptions for using IRA funds to pay for certain education or medical expenses.
Once you turn 59 ½, you can start withdrawing funds from your IRA at any rate you choose. Depending on the type of IRA you have, you may have to pay income taxes on your withdrawals.
Once you turn 73, you are required for most IRAs to withdraw a minimum amount each year. There are no mandatory withdrawals for Roth IRAs, which we’ll cover below.
How to Choose the Right Type of IRA
There are many different types of IRAs. We’ll take a closer look at how they work and help you choose the right one for your financial situation.
Keep in mind that you can open several different IRAs. However, the $6,500 annual contribution limit ($7,500 if you’re over 50) applies to your cumulative contributions to all of your IRAs.
1. Traditional IRA
With a traditional IRA, you contribute pre-tax dollars to your account. You can deduct some or all of the money you contribute to a traditional IRA from your taxable income.
However, you’ll have to pay income taxes on any withdrawals you make from your IRA after you turn 59 ½. So, a traditional IRA is typically best if you’re a high earner who expects to have significantly less income in retirement.
2. Roth IRA
A Roth IRA can be seen as the opposite of a traditional IRA in that you contribute after-tax dollars to your account. That is, you can’t deduct any contributions to a Roth IRA from your taxable income. But you pay no taxes on withdrawals from a Roth IRA in retirement.
One of the key advantages of a Roth IRA is that there is no penalty for withdrawing funds from your account before you turn 59 ½. However, you will have to pay taxes on any capital gains you withdraw, so in practice, it can be challenging to move money out of a Roth IRA before retirement without paying extra.
In general, a Roth IRA is best if you have a relatively low income right now and fall into a low tax bracket. It can also be good if you think income taxes will increase significantly by the time you retire.
3. SEP IRA
A Simplified Employee Pension (SEP) IRA is designed for self-employed individuals and business owners with any number of employees.
You make contributions with pre-tax dollars, similar to a traditional IRA. However, your annual contribution limit is increased to 25% of your net income or $66,000, whichever is less.
Note that, if you have employees, you are required to contribute to a retirement plan for each employee. The required contribution is proportional to the amount you contribute to your own SEP IRA. Keep this in mind since a SEP IRA could become a significant benefit to offer employees, but also a major cost for your business.
4. SIMPLE IRA
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is available to small business owners who have up to 100 employees. You and your employees each receive accounts. You can each contribute up to $15,000 per year, or $18,500 per year if you’re at least 50 years old.
As the business owner, you must also make contributions to employees’ accounts each year. The required contribution is a match of 3% of an employee's contributions or 2% of an employee’s annual salary (you get to choose).
A SIMPLE IRA can be a good option if you want to offer a retirement plan like a 401(k) for employees, but don’t want to deal with the complexity of managing a 401(k).
5. Self-directed IRA (IRA LLC)
A self-directed IRA, also known as an IRA LLC, allows you to invest in a wider range of assets than other types of IRAs. They’re often used if you want to invest in real estate, a business, art, or precious metals within an IRA.
Any type of IRA can be set up as a self-directed IRA with the same rules and contribution limits. You’ll typically need to hire an attorney to structure and register your IRA LLC.
IRA LLCs are typically used by high-net-worth individuals and business owners who can contribute the maximum $66,000 per year to a SEP IRA.
6. Spousal IRA
A spousal IRA is a traditional or Roth IRA designed for married couples in which one individual works and their spouse does not (or earns very little income). The spousal IRA is not a joint account, but rather an independent IRA set up in the name of the non-working spouse.
The income-earning individual can contribute to their spouse’s IRA just like they would contribute to their own IRA. So this type of IRA allows couples in which only one individual earns income to double their potential contributions. Importantly, couples with a spousal IRA must file income taxes jointly.
7. Inherited IRA
If you inherit a tax-advantaged investment account like an IRA or a 401(k), you typically have to transfer the funds to a new account. One common type of account to use for this purpose is an inherited IRA, also known as a beneficiary IRA.
The rules around inherited IRAs are complex and depend on your relationship to the deceased. A surviving spouse can roll over funds into another retirement account or convert the inherited IRA to a Roth or traditional IRA. Most other heirs are required to take annual distributions such that the inherited IRA is emptied within 10 years.
It’s a good idea to speak with a tax attorney to understand your options and obligations for an inherited IRA.
8. IRA Rollovers
You can rollover funds from a 401(k) or another retirement plan to an IRA with no penalties. This is common when you leave a job so that you can manage all of your money in one place. Rolling over from a 401(k) to an IRA also gives you access to more investment options.
There’s no limit to how much money you can roll over from a 401(k) to an IRA.
How to Open an IRA
You can open an IRA through most stock brokers. Many offer an online sign-up process that only takes a few minutes. Plus, most major brokers don’t charge any account opening or management fees for opening an IRA.
You can also open an IRA through many robo-advisor firms. These are brokers that offer pre-made investment portfolios designed to align with your financial goals and risk tolerance. Robo-advisors typically charge a monthly management fee that’s based on the amount of money you have in your IRA.
To open an account at a broker or robo-advisor, visit the service’s website and find the Open Account button. This is usually displayed prominently on the homepage. Then select the type of IRA you’d like to open.
You’ll typically need to provide your name, email, phone number, address, birthday, and social security number. You must also provide your employment status and annual income and confirm that you are not a professional investor.
Some brokers will accept your application and open your account immediately, while others take several days to review your application. Once your IRA is open, you can deposit funds from your bank account. If you plan to rollover funds from an existing IRA or 401(k), you’ll typically need to speak with an account manager at your broker.
Conclusion
IRAs offer a way to invest for retirement while lowering your tax bill. You won’t pay capital gains taxes on investment profits in an IRA, allowing you to take more advantage of compound growth. IRAs also offer more flexible investment options compared to 401(k) plans.
There are several different types of IRAs, so it’s important to think carefully about your financial goals before opening an account. You can open multiple types of IRAs and spread your contributions across them as your financial situation changes.