What is an IRA?

Gold and other precious metal IRAs are an investment and carry risk. Consumers should be alert to claims that customers can make a lot of money in these or any investment with little risk. As with any investment, you can lose money, and past performance is not a guarantee of future performance results. Consumers should also obtain a clear understanding of the fees associated with any investment before agreeing to invest.

Understanding IRAs

An IRA is a tax-advantaged way to save for retirement. Depending on the type of account you open, an IRA lets you make tax-deductible contributions during your working years or withdraw funds tax-free in retirement.

Similar to a 401(k), an IRA is a special type of investment account that lets you grow savings while enjoying certain tax advantages. IRAs are common investments for those who don’t have retirement options through their employers.

Traditional IRAs work a little like getting a deduction for charitable donations — except you’re donating to your future. Because certain taxes don’t affect IRAs, they incentivize you to save as much as you can.

Traditional IRAs provide tax deductions in the current tax year and were introduced in 1974 when Congress passed the Employee Retirement Income Security Act (ERISA). You can’t deduct Roth IRAs contributions, but all withdrawals are tax-free in retirement. They became an option after the Taxpayer Relief Act of 1997.

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IRA vs. 401(k)

The main difference is that an IRA is an “individual” retirement account that doesn’t necessarily involve your employer. A 401(k) is one of the many retirement plans offered through an employer. Other company retirement plans include a pension, 403(b) and 457. Almost anyone can open an IRA, but you can only contribute to a 401(k) if you're employed and your company offers one. Many investors have an IRA to supplement their workplace retirement plan or because their company doesn't offer it.

Traditional 401(k) retirement plans work like traditional IRAs. You make contributions pre-tax to reduce income in the current year. The money grows tax-deferred over time, so you don't owe taxes on the earnings each year. However, you'll owe ordinary income taxes on withdrawals. In theory, you'll be in a lower income tax bracket in retirement than in your peak earning years. This should result in a lower tax bill on the money withdrawn.

Contribution limits of an IRA vs. a 401(k) include:

• A 401(k) generally has higher contribution limits than an IRA.
• In 2023, investors can contribute up to $22,500 in a 401(k) vs. $6,500 for IRAs.
• Investors 50 years and older can contribute an extra $7,500 to their 401(k) and $1,000 to an IRA.

Jennifer Schell, a financial writer for Annuity.org, reminds investors that "the biggest difference between IRAs and 401(k)s is that a 401(k) is an employer-sponsored retirement plan, while an IRA is owned and managed by the individual."

Participants can’t control which investment options are available in their workplace retirement accounts. They generally have limited options, some of which may have high annual expenses. By comparison, IRA accounts can invest in various options through brokerage accounts, mutual funds, exchange-traded funds (ETFs) and more. IRAs can also invest in exotic investments, like real estate, precious metals and private businesses.

How does an IRA work?

Instead of thinking of an IRA as the actual investment, think of it as a special vault. You usually have to pay taxes when you make money on investments — such as capital gains taxes — but not on investments inside an IRA. The downside is that you have to pay taxes plus penalties (with a few exceptions) if you access the funds before turning 59 ½.

IRAs have contribution limits that dictate how much you can invest each year. These limits prevent higher earners from benefiting more from IRA tax advantages. Usually, IRA rollovers and transfers from other accounts don’t count toward that limit. Additionally, according to IRS guidelines, there's no longer an age limit for regular IRA contributions.

Contribution limits are affected by your income and other factors. As your income grows above these limits, your maximum contribution shrinks. The IRS generally counts self-employment and long-term disability as income. However, interest, dividends, alimony and child support don’t factor into modified adjusted gross income (AGI).

You can open an IRA at various financial institutions, including banks, credit unions, brokerage firms or trust companies. The IRS requires all contributions for the current year by April 18 of the following year.

Participants can't borrow from an IRA like you can with a 401(k). However, you may be able to withdraw money without penalty if you qualify for a limited number of exclusions.

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Types of IRAs

Being an IRA owner helps you make the most of your investments in stocks, bonds, real estate and even precious metals. However, different types of IRAs have unique tax advantages and requirements. Your age, income and financial goals will largely determine which type of IRA is right for you.

Traditional, self-directed and Roth IRA programs help almost anyone save for retirement. Simplified Employee Pension (SEP) and Savings Incentive Match Plan for Employees (SIMPLE) IRA plans are generally for freelancers and small-business owners. We’ve outlined the types of IRAs below to help you see which works for your retirement strategy.

IRA contribution limits

Contribution limits vary based on which type of IRA account you have. Traditional, Roth, nondeductible and self-directed IRAs have the same annual limits. As business retirement plans, SEP and SIMPLE IRAs have higher limits than individual retirement plans.

Unfortunately, most IRA contribution limits are lower than workplace retirement accounts. Some workers may need to save more than an IRA allows to meet their retirement goals. Kendall Meade, a certified financial planner and financial therapist at SoFi, says, "If you need to save more than the amount that your tax-advantaged accounts allow, in order to be on track for retirement, you can still invest that money in a taxable account to set it aside for your retirement years."

Individual retirement plan limits and factors

For 2023, the IRA contribution limit is $6,500. Additionally, investors aged 50 and older may contribute an extra $1,000 per year.

• If you don't have a workplace retirement plan, income doesn’t affect your ability to contribute to a traditional IRA. For those with a company retirement plan available, your income affects how much you can deduct even if you don't participate. For example, a single taxpayer can take the full deduction if their modified AGI is $73,000 or less. But, if their modified AGI is $83,000 or more, they get no deduction.
• A Roth IRA investor's ability to contribute depends on their income. A single taxpayer can contribute the full amount if their modified AGI is less than $138,000. If it's $153,000 or higher, then they can’t contribute to a Roth IRA.

IRA company retirement plan limits and factors

SEP and SIMPLE IRAs have different contribution limits and factors that affect participation.

• An employer can contribute up to 25% of employee compensation to a SEP IRA. The maximum contribution is $66,000 for 2023. All employees receive the same percentage contribution from the company, so self-employed businesses with no employees use this plan.
• SEP IRAs don’t allow employee salary deferrals or catch-up contributions.
• Employees can elect to defer up to $15,500 of their salary in a SIMPLE IRA. The employer can contribute a flat 2% of all salaries or a matching contribution of up to 3%.
• Participants age 50 or over may make catch-up contributions of up to $3,500 per year.

Retirement Savings Contributions Credit (Saver’s Credit)

The IRS offers a Saver's Credit of up to $1,000 per person to encourage workers to save for retirement. Your adjusted gross income, tax filing status and IRA contribution amount dictate the tax credit.

For a single taxpayer, the credit is:

• Fifty percent of your contribution if your AGI is not more than $21,750
• Twenty percent for AGI between $21,751 to $23,750
• Ten percent for AGI between $23,751 to $36,500
• No percentage for AGI over $36,500

Pros and cons of an IRA

The most significant benefits of an IRA are the tax advantages. IRAs have specific requirements for contributions and when you can take out money (for example, having to pay penalties and taxes when withdrawing before age 59 ½). However, the straightforward nature of investing in an IRA is attractive to most novice investors.

We’ve broken down some of the main advantages and disadvantages of a traditional IRA below.

How to open an IRA

Opening an IRA is a fairly simple process, no matter where you open your account. Many financial services companies allow you to open your account online, over the phone or in a local office. In some cases, you can open an account through the company's mobile app.

When looking for a company to open your IRA, Jennifer Schell, a financial writer for Annuity.org says: "Determine which features are most important to you. Look for things like advisory fees, investment variety, account minimums and any interactive tools the provider offers that can make managing your portfolio easier. You can also read reviews on third-party websites to find out how other customers feel about the IRA provider."

To open your account, you'll need to gather basic personal information, such as:

• Full name
• Mailing address
• Phone number
• Date of birth
• Social Security Number
• Beneficiary information
• IRA contribution

In most states, anyone over the age of 18 can open a traditional or Roth IRA in minutes with only simple background information. You’ll need to choose where to open your IRA and what you want to invest in. Almost anyone can open up an IRA at most banks and financial institutions, regardless of whether or not they already have a 401(k) or another type of retirement savings plan.

The minimum contribution to open your IRA depends on your provider. Some IRAs don’t require a minimum amount of money to open. However, some providers or investments have minimum contribution requirements. Some will reduce or eliminate the minimum contribution if you agree to automatic contributions from your bank account.

Bottom line

An IRA is a tax-advantaged investing tool with plenty of benefits, but every investment has some risk. Many types of IRAs exist, depending on your goals and investing strategy. Traditional IRAs have existed since the 1970s, but now Roth IRAs are becoming increasingly popular. For those who want flexibility, a self-directed IRA might be the way to go.

Learn more about your investing options, including how to find the best financial advisor or mutual fund company.