What is an IRA and how does it work?

An individual retirement account (IRA) is a tax-advantaged savings plan available to anyone with earned income. Unlike 401(k) plans, IRAs are opened by an individual and are not sponsored by an employer.

In September 2023, there was approximately $12.6 trillion invested in IRAs, according to the Investment Company Institute.

Below, CNBC Select walks you through the ins and outs of different IRAs, including eligibility requirements, contribution limits and tax implications.

An IRA allows you to invest pre-tax money into different asset classes, including stocks, bonds and mutual funds. Since the money typically isn't taxed, there is more to invest.

Anyone with earned income can open an IRA through a bank, robo-advisor, brokerage or other financial institution. There are annual contribution limits, however, and you must typically wait until age 59 ½ to start making withdrawals without penalty, according to the IRS.

Depending on your filing status, your income and whether you have a retirement plan through your job, part or all of your IRA contributions can be deducted from your taxable income.

If you have money in a 401(k) plan or another employer-sponsored retirement account that you no longer contribute to, it can usually be rolled over into an IRA and retain its tax-deferred status.

There are several types of IRAs, with varying rules about contributions, taxation and distributions. You can have multiple IRA accounts, but annual contribution limits are cumulative.

Traditional IRA

Traditional IRAs are the most common form, with 31% of U.S. households having one, according to a February 2024 report from the Investment Company Institute. Your contributions can lower your taxable income for that year, though there is a cap of $7,000 in 2004 ($8,000 if you're 50 or older). When you withdraw funds later, you'll pay taxes on the full amount being taken out

If you make a withdrawal from your IRA before age 59½, there is usually a 10% penalty. And starting at age 73, you must start making withdrawals, referred to as required minimum distributions (RMDs).

Vanguard offers traditional and Roth IRAs, with no commission fees for stock and exchange-traded fund trades, no brokerage fee if you sign up for e-statements and no transaction fees for more than 3,000 mutual funds. The Vanguard Digital Advisor robo-advisor is available for a 90-day free trial.

Roth IRA

Unlike other IRAs, contributions to Roth IRAs are taxed before they're deposited. That gives you less to invest but can be useful if you expect to be in a higher tax bracket when you retire.

Roth IRAs aren't subject to RMDs but they do come with income caps: $153,000 for individuals, $228,000 for married couples filing jointly and $10,000 for married couples filing separately.

Fidelity Investing offers traditional, Roth and rollover IRAs, with no minimum to open an account. If your balance is over $25,000, you get free access to Fidelity advisors.

SEP IRA

A Simplified Employee Pension (SEP)-IRA allows self-employed workers and small business owners to contribute to a traditional IRA set up for themselves or their employees. Only employers contribute to these plans and all eligible employees need to receive equal contributions.

To qualify for a SEP-IRA, you must be at least 21, have worked at your company for three of the past five years and earned at least $750 in taxable income.

SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is aimed at businesses with 100 or fewer employees. Employers can either make a mandatory contribution of 2% of an employee's income or a dollar-for-dollar match of their contribution, up to 3%. 

To be eligible for a SIMPLE IRA, employees must receive at least $5,000 in the current year, as well as two prior years. Employees can also contribute to a traditional or Roth IRA.

If you have earned income, you can open an IRA at a bank, brokerage or other financial institution. Shop around for a firm with fees, customer service and a track record you feel comfortable with.

Charles Schwab offers traditional, Roth and rollover IRAs with no fees or minimums and a wide array of commission-free stocks, options and exchange-traded funds. If you prefer a hands-off approach, the Schwab Intelligent Portfolios robo-advisor offers automatic rebalancing and tax-loss harvesting.

Investing app Robinhood offers an unlimited 1% match on IRA transfers to a Robinhood traditional or Roth IRA. In addition to the matched contribution, deposits of up to $1,000 are available to invest immediately and the app provides a variety of investment recommendations.

Each year, the IRS caps on how much you can invest in an IRA, though the dollar amount varies by account type. For the 2024 tax year, the limit on traditional and Roth IRAs is $7,000 ($6,500 for tax year 2023). For individuals 50 or older, the limit is $8,000 in 2024 ($7,500 for 2023).

The 2024 limit for a SEP-IRA is either 25% of an employee's income or $69,000, whichever is less. (The dollar limit for tax year 2023 is $66,000.)  

The contribution limit for SIMPLE IRAs is $16,000 in tax year 2024 ($15,500 in 2023), plus an additional $3,500 catch-up contribution for working Americans 50 and older.

Both IRAs and 401(k) plans are usually tax-deferred, but a 401(k) is offered through an employer while an IRA is opened by the individual. Many people have both an IRA and a 401(k), which can diversify your portfolio and protect you from market fluctuations.

IRAs usually offer more investment options and allow you to contribute to the same plan even if you change jobs. On the flipside, there is no employer match with a traditional IRA and contribution limits are lower.

In addition, unlike a 401(k), you cannot take a loan out against your IRA.

You can begin making penalty-free withdrawals (called qualified distributions) from a traditional IRA starting at age 59½. If you take money out before then, you'll have to pay a 10% penalty in addition to the standard income taxes.

There are a few exceptions, such as paying for higher education, medical expenses, the birth/adoption of a child or recovering from a disaster.

If you have a Roth IRA, it must be opened for at least five years to avoid a penalty, according to the IRS, even if you're over 59½. If you make an early withdrawal from a Roth IRA that's at least five years old, you only pay taxes and penalties on any earnings that have accrued: So, if you contributed $10,000 to your IRA and it's earned $2,000 interest, you could withdraw up to $10,000 without a fee.

There are some exceptions for penalties on Roth IRAs, including for first-time homebuyers and higher education.

An early withdrawal from a SIMPLE IRA is assessed a 10% penalty. If it's within two years of the account opening, however, the amount increases to 25%.

Once you reach age 73, you are required to withdraw a minimum amount from your IRA each year. (Roth IRAs are exempt from these annual distributions.)

The size of your annual RMD depends on your age, marital status and the cumulative amount in all your IRAs. RMDs can be taken from a single account or from across several.

An IRA is a great option for those who want to maximize their retirement savings beyond the traditional 401(k). You can contribute to an IRA as long as you are earning income, but it doesn't need to be sponsored by your employer. It's important to know about the different types of IRA to make the best financial decision.

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