IRAs, or Individual Retirement Accounts, are investment accounts that allow you to save for retirement in a tax-efficient way. You can also use an IRA to transfer, or “roll over” money from 401(k)s and other retirement accounts, tax-free.
Similar to 401(k) accounts, IRAs allow you to invest your savings in stocks, bonds, ETFs, and other assets. They have similar tax advantages in that you can deposit money before taxes and it gets to grow tax-free until the time of withdrawal.
Also similar to 401(k)s, there are withdrawal restrictions: you may face a 10% early withdrawal penalty and pay ordinary income tax on the money you withdraw before age 59 1/2 unless you qualify for an exception.
There are two main types of IRAs, Traditional and Roth, each with specific tax benefits.
How do IRAs work?
You can open an IRA brokerage account at many financial institutions, like a bank, broker, or robo-advisor. If you open an IRA at a broker or robo-advisor, you’ll be able to invest in stocks, bonds, and other traded assets.
IRAs from banks generally offer certificates of deposit and IRA savings accounts — these accounts typically offer a fixed rate of interest over a certain period of time. Since rates have risen recently, these accounts are more appealing now than they have been over the last decade.
- Self-Directed IRAs allow individuals to manage their investments on their own at online brokers like Fidelity, Charles Schwab, Vanguard, E*Trade, or TD Ameritrade. They’re typically used by more active investors who want more control over their portfolios. Most self-directed IRAs allow you to invest in a full range of stocks, bonds, Exchange-Traded Funds (ETFs), and options. Some IRAs even allow you to invest in alternative assets like real estate or cryptocurrency. It’s best practice to look for a commission-free IRA with low fees and for investments with reasonable expense ratios.
- Automated (Robo-Advisor) IRAs (offered by Betterment and other trading platforms) set up a portfolio for you and use technology to automatically rebalance it (by making ETF trades) over time. This makes them a good fit for people who want to outsource their investing decisions or don’t feel qualified to make their own trades. To use these accounts, you’ll generally pay an annual fee that’s expressed as a percentage of your assets, known as a “management fee” or an “advisory fee”. Some robo-advisors offer access to a team of Certified Financial Planners (CFPs) in the event you have questions for a human.
How do I contribute to an IRA savings account?
While many 401(k)s require contributions to come directly from a paycheck before taxes, IRAs allow you to contribute after-tax dollars. At most providers, you can contribute online using your computer or mobile device.
Depending on the type of IRA and your annual compensation, taxpayers under 50 years old can contribute up to $6,500 a year (total) to their IRAs in the tax year 2023. Those who are at least 50 years old by the end of the tax year can contribute an additional $1,000, for a total of $7,500 in the tax year 2023.
1. Traditional IRAs
Traditional IRAs allow individuals to make contributions with money that may be deductible on their tax return. Earnings contributed to a traditional IRA can grow tax-deferred until you withdraw them in retirement, similar to those in a 401(k). For these reasons, we call them “tax-me-later” accounts — the money usually goes in and compounds tax-free, but tax is paid on withdrawal.
When you retire, you might find yourself in a lower tax bracket than you were when you were working, so the tax deferral allows you to pay tax at that lower rate when you finally withdraw the money.
Contributions to traditional IRAs are often tax-deductible, meaning if you contribute $6,500 to a traditional IRA, it could reduce the amount of your taxable income by $6,500. That means if the money you contributed to a traditional IRA already had taxes withheld from it, you may be able to deduct the contribution amount from your taxable income and potentially get the tax dollars back as a refund.
The amount of your contribution that you can deduct on your tax return also varies. If you’re covered by a 401(k) or any other employer-sponsored retirement plan, your Modified Adjusted Gross Income (MAGI) will determine how much of your contribution you can deduct—if any.
In other words, if you earn beyond the IRS-prescribed limits and/or if you have a retirement plan at work, you likely won’t be able to deduct your entire IRA contribution on your tax return. It’s best to check with the IRS or a Certified Financial Planner to see how much of your IRA contribution might be deductible — most planners will have calculators that can help you figure this out in advance.
2. Roth IRAs
Roth IRAs allow individuals to make contributions with money they’ve already paid taxes on. With a Roth IRA, your money can grow tax-free, complete with tax-free withdrawals in retirement.
This means that, unlike other investment or savings accounts where you pay tax on the interest or dividends as time passes, the gains from a Roth IRA are not subject to tax as long as you’ve held your account open for at least five years and are at least 59.5 years of age.
To keep it simple, think of Roth accounts as “tax-me-now” accounts — you pay taxes before putting the money in, but then you generally get to withdraw it tax-free.
The IRS limits the tax advantages of Roth accounts to people earning below a certain amount. To use a Roth in this way, your taxable income cannot exceed $153,000 in 2023 if you’re single, or $228,000 if you’re married and filing jointly.
Direct contribution limits to Roth IRAs start at $6,500 and begin phasing out or decreasing at $138,000 (single filers) and $218,000 (married filing jointly) in 2023.
3. Rollover IRAs
A rollover IRA is a type of IRA that’s tagged to receive money from another retirement account. This transfer is known as an “IRA rollover”. IRA rollovers involve moving eligible assets from an employer-sponsored retirement plan, such as a 401(k) or 403(b), into an IRA.
401(k) rollovers are not subject to the standard contribution limits, because they aren’t contributions at all. Since these are previously saved amounts, there’s no upper limit on how much money you can transfer in a rollover transaction. There shouldn’t be any transaction fee associated with a rollover, and there isn’t any minimum balance requirement to move out your old retirement funds.
You will have to have separated from your previous employer, though, to be eligible for an IRA rollover. You’ll also need to make sure that your rollover IRA matches the tax status of the account you’re moving in. For example, if you have a pre-tax 401(k) at your former employer, you’ll want to open a traditional IRA to receive your old plan. If you have a Roth 401(k), your rollover IRA should also be a Roth IRA.
- IRAs are an effective way to consolidate your retirement savings. Many people use an IRA to consolidate all their retirement assets from old 401(k)s. IRAs tend to be easier to track since they’re directly linked to you and you have some control as to where it’s held. As mentioned, IRAs also tend to have a greater range of investment options.
- Some people may not have access to a workplace retirement plan like a 401(k). While 401(k)s are great ways to save money, not every employer offers one. Opening up an IRA allows those who don’t have access to a workplace account to get many of the same advantages.
- IRAs have tax advantages that general investment or savings accounts don’t. IRAs have valuable tax benefits compared to a general taxable brokerage account. Money in an IRA gets to grow tax-advantaged — this can benefit your account balance in a big way, especially when applied over long time horizons.
- IRAs allow you to invest your savings into stocks, bonds, ETFs, options, and even real estate or cryptocurrency. These are often higher-returning investments than nominal interest rates provided by other savings accounts. 401(k)s usually only offer mutual funds and potentially a company stock fund as investment options.
There are a few factors to consider when deciding on an IRA provider for your new account. Most people compare based on fees, investment products, or by choosing an institution they’re familiar with.
Most large financial institutions offer an IRA of some type, most with no account minimum required. No matter which provider you choose, you can always change providers down the line if you change your mind. IRA-to-IRA transfers are generally easy, so you’re not locked in!
If you’re unsure, you can also contact each provider’s customer support service to see if their IRA offering meets your needs.
To help you compare, we’ve compiled a list of popular providers in the following categories: