What is an IRA?

How does an IRA work?

An IRA, or individual retirement account, offers a tax-advantaged way to help save for retirement. There are two main types of IRAs (traditional and Roth) which may be available for individuals with income. Small business owners or independent contractors may have the option to open SEP or SIMPLE IRAs.

Here is an overview of how each type of IRA works:

Traditional IRA: With this type of account, annual contributions may be tax deductible depending on whether you (or your spouse) are covered by a retirement plan at work and your income exceeds certain levels. However, even if your income exceeds the income limit to qualify for a tax deduction, you can still contribute after-tax dollars to a traditional IRA (up to the applicable annual limit described below). When you make a withdrawal from a traditional IRA, contributions that were tax deductible and earnings are included in your taxable income (meaning they are subject to tax at your ordinary income rate).

Roth IRA: The tax advantages of a Roth IRA are essentially the reverse of a traditional IRA’s tax advantages. With this type of account, you have paid taxes on the money you contribute, but you do not pay taxes on “qualified distributions” (meaning, the withdrawals that meet the requirements of the Internal Revenue Code for tax-free treatment). This means that your contributions to a Roth IRA could grow tax free. However, your income must be below the income limit set by the IRS for you to make an annual contribution to a Roth IRA.  

A backdoor Roth (or Roth conversion) allows for some or all of traditional IRA or 401(k) assets to be converted to a Roth IRA (subject to applicable taxes). This may be an appropriate option if you (and your legal and/or tax professional) believe a Roth IRA would be best for your situation. Please consult your legal and/or tax professional to see whether this is an appropriate option for you. 

SEP IRA: This type of account is often used by independent contractors, freelancers and small business owners with few or no employees. SEP stands for Simplified Employee Pension. Like a traditional IRA, contributions to a SEP IRA may be tax deductible, and withdrawals are includable in taxable income. SEP IRAs may also now be designated as SEP Roth IRAs if the option is available with the provider.  

SIMPLE IRA: This type of account is used by small businesses with 100 or fewer employees. The SIMPLE acronym stands for Savings Incentive Match Plan for Employees. Like with traditional IRAs and SEP IRAs, contributions are generally tax deductible (or pre-tax, in the case of employee salary reduction contributions), and withdrawals are includible in taxable income. Similar to SEP IRAs, SIMPLE IRAs may also now be designated as SIMPLE Roth IRAs if the option is available with the provider.   

For individual investors, the choice usually comes down to a traditional IRA or a Roth IRA. When making this choice, think about if you would rather receive a tax break while you are working or while you are retired. If you are able to make annual contributions or convert assets to a Roth IRA and you believe you will be in a higher tax bracket in the future, it might make sense to choose a Roth IRA because you may be able to make withdrawals tax free. In contrast, if you expect to pay lower taxes during retirement and you qualify for the tax deduction, getting the upfront tax advantages of a traditional IRA might be a better choice. Consult your tax professional if you have any questions.

If you can’t decide between the two, as noted above you may be able to convert traditional IRA or 401(k) assets to a Roth IRA, and you are allowed to make regular annual contributions to both a traditional and a Roth IRA (if you are below the Roth IRA income limit) during the same year, provided you have adequate taxable compensation and the total amount you contribute is below the maximum allowable contribution limit. For 2023, the limit is $6,500 for people below 50 and $7,500 for those 50 or older.

You may be able to contribute to an IRA while also contributing to other retirement accounts, such as a 401(k). An IRA may give you more control over your investments than a 401(k). Many IRAs offer you more investment options than some 401(k)s, including stocks, bonds, mutual funds and exchange-traded funds (ETFs). 401(k)s and other employer-sponsored qualified retirement plans generally have higher contribution limits set by the IRS, and your employer may offer matching contributions. It is a good idea to review the benefits and fees of each to assess your options.

You may be able to open an IRA in a matter of minutes. You should select the type of IRA you want to open and decide how hands-on or hands-off you want to be with making investment decisions about the account. As you think through these questions, talking to a financial advisor can be a helpful place to start.

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