An individual retirement arrangement (IRA) is a personal savings plan that offers specific tax benefits. IRAs are one of the most powerful retirement savings tools available to you. Even if you’re contributing to a 401(k) or other plan at work, you might also consider investing in an IRA.
What types of IRAs are available?
The two major types of IRAs are traditional IRAs and Roth IRAs. Both allow you to contribute as much as $6,500 in 2023 ($6,000 in 2022). You must have at least as much taxable compensation as the amount of your IRA contribution. But if you are married filing jointly, your spouse can also contribute to an IRA, even if he or she has little or no taxable compensation, as long as your combined compensation is at least equal to your total contributions. The law also allows taxpayers age 50 and older to make additional “catch-up” contributions. These folks can contribute up to $7,500 in 2023.
Both traditional and Roth IRAs feature tax-sheltered growth of earnings. And both give you a wide range of investment choices. However, there are important differences between these two types of IRAs. You must understand these differences before you can choose the type of IRA that’s best for you.
Note: Special rules apply to certain reservists and national guardsmen called to active duty after September 11, 2001.
Learn the rules for traditional IRAs
Practically anyone can open and contribute to a traditional IRA. You can contribute the maximum allowed each year as long as your taxable compensation for the year is at least that amount. If your taxable compensation for the year is below the maximum contribution allowed, you can contribute only up to the amount that you earned.
Your contributions to a traditional IRA may be tax deductible on your federal income tax return. This is important because tax-deductible (pre-tax) contributions lower your taxable income for the year, saving you money in taxes. If neither you nor your spouse is covered by a 401(k) or other employer-sponsored plan, you can generally deduct the full amount of your annual contribution. If one of you is covered by such a plan, your ability to deduct your contributions depends on your annual income (modified adjusted gross income, or MAGI) and your income tax filing status.
For 2023, if you are covered by a retirement plan at work, and:
• Your filing status is single or head of household, and your MAGI is $73,000 or less, your traditional IRA contribution is fully deductible. Your deduction is reduced if your MAGI is more than $73,000 and less than $83,000, and you can’t deduct your contribution at all if your MAGI is $83,000 or more.
• Your filing status is married filing jointly or qualifying widow(er), and
your MAGI is $116,000 or less, your
traditional IRA contribution is fully deductible. Your deduction is reduced if your MAGI is more than $116,000 and less than $136,000, and you can’t deduct your contribution at all if your MAGI is $136,000 or more.
• Your filing status is married filing separately, your traditional IRA
deduction is reduced if your MAGI is less than $10,000, and you can’t deduct your contribution at all if your MAGI is $10,000 or more.
For 2023, if you are not covered by a retirement plan at work, but your spouse is, and you file a joint tax return, your traditional IRA contribution is fully deductible if your MAGI is $218,000 or less. Your deduction is reduced if your MAGI is more than $218,000 and less than $228,000, and you can’t deduct your contribution at all if your MAGI is $228,000 or more.
What happens when you start taking money from your traditional IRA? Any portion of a distribution that represents deductible contributions is subject to income tax because those contributions were not taxed when you made them. Any portion that represents investment earnings is also subject to income tax because those earnings were not previously taxed either. Only the portion that represents nondeductible, after-tax contributions (if any) is not subject to income tax. In addition to income tax, you may have to pay a 10% early withdrawal penalty if you’re under age 59 1/2, unless you meet one of the exceptions. You must aggregate all of your traditional IRAs — other than inherited IRAs — when calculating the tax consequences of a distribution.
If you wish to defer taxes, you can leave your funds in the traditional IRA, but only until April 1 of the year following the year you reach age 73 (72 if reached before January 1, 2023). That’s when you have to take your first required minimum distribution (RMD) from the IRA. After that, you must take an RMD by the end of every calendar year until you die or your funds are exhausted. The annual distribution amounts are based on a standard life expectancy table. You can always withdraw more than you’re required to in any year. However, if you withdraw less, you’ll be hit with a 25% penalty on the difference between the required minimum and the amount you actually withdraw. This penalty may be reduced to 10% if corrected in a timely manner.