What is an IRA? Answers to 13 Most Common IRA Questions

When it comes to building a secure financial future, one of the best things you can do is save for retirement using a tax-advantaged retirement account. And, if you’re looking for more control over what’s in that account, an Individual Retirement Account (IRA) might be just the thing.

With 66 percent of employed Americans between the ages of 21 and 32 claiming to have no savings for retirement at all, now is the time to go against the grain and work toward building up your own retirement accounts, especially if you've entertained the idea of early retirement. 

But what is an IRA? How does it work and what does IRA mean? What are the benefits? Let’s answer some of the most common questions people ask about IRAs.

1. What is an IRA?

An IRA is an investment account that allows you to save for retirement. You can keep many different types of assets in an IRA, allowing the value to grow over time. Because it’s designed for retirement, though, there are penalties when you withdraw the money early.

The good news, though, is that IRAs are generally flexible, and offer different benefits.

2. Are IRAs and 401(k) Accounts the Same Thing?

No, they aren’t. An IRA, as an individual retirement account can be opened by anyone with earned income, no matter what other investment accounts they have. You can even get a self-directed IRA and choose from a variety of assets to keep in the account.

On the other hand, a 401(k) is usually offered through your workplace. While it’s possible to open a solo 401(k) as a business owner, the reality is that you’re more likely to encounter this type of retirement account at work. You’re limited as to investment options, which are chosen by whoever your company hires to administer the 401(k) plan.

Additionally, contribution amounts are higher for 401(k) accounts.

3. What’s the Difference Between a Traditional and a Roth IRA?

These two types of IRAs are distinguished by their tax treatment.

With a traditional IRA, you make your contributions before you pay taxes. You get a tax deduction today, benefiting you now. However, later on, when you withdraw money from the account during retirement, you have to pay taxes on it as if it’s regular income. On top of that, later on down the road, you’re required to take minimum distributions from your IRA.

When you choose a Roth IRA, though, you make contributions after you pay taxes. You don’t get an immediate benefit. However, the money grows tax-free. As a result, when you withdraw money in the future, you aren’t taxed on it. Plus, there are no required minimum distributions when you have a Roth IRA.

Income Limits for Roth IRAs and Phaseouts for Traditional IRAs

With a Roth IRA, you can only contribute if you fall within the income criteria. For 2023, when you reach $138,000 a year as a single filer ($218,000 married), you can only make a partial contribution, and once you reach $153,000 a year (or $228,000 married), you can’t contribute to a Roth at all.

In 2024, when you reach $146,000 a year as a single filer ($230,000 married), you can only make a partial contribution, and once you reach $161,000 a year (or $240,000 married), you can’t contribute to a Roth.

For a traditional IRA, if you or your spouse has a retirement account at work, your tax deduction is phased out once you reach a certain income level, so it’s important to plan ahead and carefully consider where you’re putting your retirement dollars.

Which is better? Traditional or Roth?

There’s no “right” answer about which type of IRA to get. Basically, it’s all about what you think your tax situation will be in the future, versus how it is now.

If you think you’ll be in a higher tax bracket during retirement, or if you think taxes will be higher down the road, a Roth can be a good choice. When I got my first job, I wasn’t making enough money to pay taxes anyway. After-tax contributions didn’t matter — I wasn’t paying taxes to begin with! So socking money away in a Roth made sense.

However, if you think that you’ll be in a lower tax bracket in retirement, and you want lower your tax liability in the present, a traditional IRA might be a better choice.

And don’t worry — you can have both a traditional and a Roth IRA. You just have to realize that there are combined contribution limits.

4. What are the Benefits of an IRA?

Most of the benefits have to do with taxes. With a traditional IRA, you see tax-deferred growth and with a Roth IRA, you see tax-free growth.

You can use your IRA to fund a first-time home purchase of up to $10,000, or you can use it to pay education expenses, without having to pay the penalty for early withdrawal.

With the Roth IRA, there is an added benefit: you can withdraw the money you contribute anytime you want without worrying about paying penalties or taxes. However, you have to be careful because if you withdraw any of your investment earnings early, you’re subject to penalties and taxes on those gains.

However, you might be better off leaving that money in your account to grow instead of falling prey to the opportunity cost that comes when the money isn’t working on your behalf.

The main benefit to any retirement investment account is that you’re building wealth for the future. Your money is earning money.

5. What Happens if I Need to Withdraw Money from an IRA?

Because this is a tax-advantaged retirement account, you’re not supposed to take money from your IRA until you reach age 59 ½.

With an IRA, early withdrawal — before the age of 59 ½ — comes with a 10% penalty. And you might even owe taxes on the money you take. You can get around that in certain cases, such as buying a first home or paying for an education, though.

It’s also possible to take what amounts to short-term loans from your IRA. If you withdraw money, you don’t have to worry about penalties and taxes as long as the same amount goes back into a qualified retirement account within 60 days.

With your Roth IRA, you have to meet the five-year rule before you can start withdrawing your earnings from the Roth IRA without paying taxes. Even if you’re above age 59 ½, the five-year rule applies if you want to avoid paying taxes on your earnings withdrawal.

6. How Much Can I Contribute to an IRA Annually?

Each year, the IRS reviews inflation data and other information to determine the annual contribution limits for IRAs. The IRS also sets income limits and deduction phaseouts every year.

For a traditional or Roth IRA, the contribution limit in 2024 is $7,000 per year. This is the total amount you can contribute to both IRAs. So if you contribute $4,000 to a Roth IRA, you can only contribute $3,000 to a traditional IRA. If you have both types of IRA, make sure you’re keeping track of where the money is going.

7. What are “Catch Up” Contributions?

If you’re at least 50 years old, you can put an extra $1,000 into your IRA (for tax year 2023 and 2024). These “catch up” contributions are designed to help those close to retirement get a little extra into their accounts.

8. What is a Modified Adjusted Gross Income (MAGI) and How Do I Calculate Mine?

Whether you qualify to contribute to a Roth IRA or when your traditional IRA deduction phases out have to do with your MAGI. Now, this is a weird calculation. When you look at your Form 1040, you’ll take some deductions, like student loan interest, that reduce your income. As you get to Line 37, you’ll see your Adjusted Gross Income (AGI).

However, your MAGI is your AGI with certain deductions added back to your income. Here’s what you add back to AGI to calculate your MAGI:

• Tuition and fees deduction
  
• Qualified tuition expenses deduction
  
• Student loan interest deduction
  
• Exclusions for adoption expenses
  
• Deductions for IRA contributions you’ve made
  
• Passive losses
  
• Rental losses
  
• Losses from a publicly traded partnership
  
• Exclusions for the income received from U.S. savings bonds
  

The reality is that you probably won’t be claiming many of these deductions. If none of these things apply, then your AGI and MAGI are the same. However, you might claim one or two of these special cases, and that could make a difference. So, when figuring out whether you’re eligible for certain IRA benefits, double-check your MAGI.

9. How Do I Open an IRA?

Opening an IRA is fairly straightforward. As long as you have earned income, you can contribute to an IRA. All you have to do is find a provider and go through the process. You do need some paperwork, including:

• Legal name
  
• Birthdate
  
• Address
  
• Phone number
  
• Social Security number
  
• Account and routing information for the institution that you plan to use to fund your IRA
  

In many cases, though, you can open an IRA online in under 10 minutes. Many online brokers and robo-advisors offer IRAs — including Roth accounts. You can find IRAs from robo-advisors like Betterment, Wealthfront, and Wealthsimple in addition to brokerages like Vanguard, Fidelity, and E*TRADE from Morgan Stanley.

10. How Should I Invest in an IRA?

The easiest way to learn how to invest money in an IRA is to set up automatic contributions. Most IRA providers allow you to set up regular contributions that are taken from your checking or savings account each month. This is the easiest way to start investing in an IRA because it takes the thinking out of the equation. Consistency is your best friend when you want to build long-term wealth through investing.

As far as what you can hold in an IRA, it’s possible to hold a number of assets, including real estate, in your account. However, most brokers prefer to offer a range of stock and bond index funds and ETFs for you to choose from. Opening a self-directed IRA with a boutique firm is always a possibility, but there are restrictions regarding what types of businesses and real estate assets you can hold in an IRA, so it’s important to work with a professional who thoroughly understands the requirements.

For most investors, a portfolio allocated between stocks and bonds is adequate. But it’s really up to your own comfort level when deciding what to keep in your IRA.

11. Rollover IRAs: What are They and Why Would I Need to Do It?

You might have heard of Rollover IRAs. These IRAs are usually created when you take money from a different retirement account and move it (“roll it over”) into an IRA.

One of the most common reasons to complete a rollover is to move money from a company 401(k) into an IRA, where the money is more accessible. 

Here are two prominent reasons for moving the money:

• You leave your job: If the company no longer employs you, you might be required to take the money from your 401(k). If you simply take the payout, you could actually end up getting slapped with penalties and paying taxes. Instead, if you perform a rollover (your new IRA provider can help you with the process), you don’t have to worry about those penalties.
  
• You don’t like the options in your 401(k): In some cases, you might be unhappy with your company 401(k). Maybe the fees are too high, or you can’t invest in the ETF you’ve got your eye on because it’s not offered in the plan. It’s possible to opt out of contributions and roll the money into your IRA. However, it’s important to be careful when doing this. The contribution limit for a 401(k) is $23,000 for 2024 and $22,500 for 2023 — the much higher limit might make up for the inconveniences of the company plan. Plus, if your company offers a 401(k) match, you could miss out on free money.
  

As long as you are moving money from a traditional 401(k) into a traditional IRA, the transition should be smooth, and you shouldn’t need to worry about taxes.

Rolling Funds Into a Roth IRA

Things are a little different if you do a Roth IRA rollover. If you’re rolling funds from a Roth 401(k) into a Roth IRA, there’s no problem. But what happens if you want to rollover from a regular 401(k) into a Roth IRA?

Since a Roth IRA is all about after-tax contributions, you’re required to pay taxes on the amount you roll over. For some folks, the idea of a “backdoor” into a Roth IRA that they might not otherwise be able to contribute to is tempting. Before you make the move, though, review the tax consequences and make sure it’s worth it.

12. What is a SEP IRA and How Does It Work?

A SEP IRA is designed for employers to make contributions to their employees. Only employers can contribute to these accounts, up to the lesser of 25% of the employee's compensation, or $69,000. Employees don’t make contributions, but the money becomes theirs once an employer makes the contribution, and withdrawal rules and early distribution penalties apply.

If you’re a business owner that wants to set up a SEP IRA and take advantage of a potentially higher annual contribution, you need to realize that you have to contribute to all your employees’ plans as well.

13. What is a SIMPLE IRA and How Does It Work?

There are two formula possibilities for a SIMPLE IRA:

• Employee contribution with match: Employees can contribute up to 3% of their salary and get a match from the employer.
  
• Employer contribution only: The employer contributes 2% of the employee’s salary to their SIMPLE IRA, while the employee contributes nothing.
  

In general, if you’re a business owner who wants to set up a SEP or SIMPLE IRA for yourself and you’re willing to contribute to your employees as well for the tax benefits, a SEP is considered more flexible, since you can change contributions from year to year.