If you contribute to a traditional individual retirement account, you can deduct the amount of your contribution from your taxable income up to the annual IRA contribution limits. When you later withdraw money from the account, usually in retirement, you will pay tax on the money as you withdraw it, often at a lower income tax rate than in your prime working years. How much you'll save in taxes depends on how much you contribute and your tax rate.
At the end of the year, you can deduct the amount of your IRA contribution from your taxable income.
How an IRA Works
An IRA is a type of account that you can open for yourself with financial institutions like banks, brokerages and credit unions. Within the IRA, you can invest in a wide range of offerings like stocks, bonds, mutual funds, index funds and, if your institution offers them, banking products like certificates of deposit.
As of 2019, you can contribute up to $6,000 per year to your IRAs, or up to $7,000 if you are 50 or older. This is up from a $5,500 tax break limit for 2018 and earlier years. To reach the IRA tax break limit, you must contribute your own earned income or your spouse's earned income, so if you earned less than $6,000 in a year, you can only contribute to the extent that you earned.
When you file your taxes, you can claim an IRA tax deduction for your contributions. How much you will save depends on how much you contribute to the plan and what your tax bracket rate is.
When you are over age 59 1/2, you can begin to withdraw money from your IRA without a tax penalty. You will then pay tax on the money you withdraw at your tax rate at the time. If you withdraw money from an IRA before age 59 1/2, you will generally have to pay tax on the funds plus a 10 percent penalty to the Internal Revenue Service unless special limited circumstances apply.
How a Roth IRA Works
A Roth IRA works differently from a traditional IRA. With a Roth IRA, you contribute money to the account and pay tax on it as usual. You might be wondering, "Will opening a Roth IRA reduce my taxes?" It will, but only in the long run.
When you withdraw money from the account in your senior years, you do not need to pay any additional tax, including on any earnings your investments have racked up over the years. That means that your Roth IRA will save you money on tax in retirement when you take distributions, or payments, from the account rather than in your working years. A Roth IRA can be a good option if you anticipate big returns from your investment or being in a high-income tax bracket in retirement.
The IRA contribution limit includes all of your traditional and Roth IRAs.
Penalty-Free Early IRA Withdrawals
There are certain situations where you can take an early withdrawal from an IRA without facing a penalty.
You can do so if you are totally or permanently disabled, if you have medical expenses in excess of 7.5 percent of your income or if you need to use the money to pay for health insurance for yourself or your family while you are unemployed. You can also withdraw up to $10,000 for the purchase of your first home or to pay for certain qualifying higher education expenses.
You can also take money out of an IRA without penalty in certain circumstances if you are called to active duty from the military reserves. You also won't face a tax penalty if the money in your IRA is seized by the IRS to pay a tax bill. Special rules also apply if you inherit an IRA.
Generally, you will still have to pay income tax at your usual rate on what you withdraw from an IRA, even if one of the exceptions apply. You will also have to decide whether it makes more financial sense for you to take money from the IRA or use other savings or a loan to pay whatever expenses are involved.
Rolling Over an IRA
If you are dissatisfied with the bank or brokerage where you have your IRA, you can move the money to another financial institution without a penalty. Generally, the easiest way to do this is to work with the company receiving the money to transfer the funds without them coming directly into your possession.
If you do receive the money by check or electronically, you must deposit it into a new eligible retirement account within 60 days or you will owe tax plus potentially the 10 percent penalty as if you had made an ordinary withdrawal. You can only make one rollover, as this process is called, from each IRA in a one-year period. If you roll money into an IRA, you also can't then roll money out of the new IRA within that period.
Investments and Tax Considerations
When you're deciding what types of investments to hold in an IRA versus a traditional bank or brokerage account, taxes will likely be one of the factors that you consider. Note that if you hold on to stocks, bonds or real estate outside of an IRA for more than one year and then sell them for a profit, you will be taxed at the long-term capital gains tax rate rather than your ordinary income tax rate.
This rate is 15 percent for most taxpayers and 0 percent or 20 percent for others depending on your overall income. For most taxpayers, that's less than you would pay on ordinary income, such as money you earned from work or bank interest. If you sell investments at a loss, you can deduct the capital loss from other capital gains or, to a limited extent, from your ordinary income. You can roll unused capital losses into future tax years, although you can't roll them backward to offset prior gains.
Depending on your anticipated returns, you may decide to hold some investments in IRAs and other tax-advantaged retirement accounts and others in traditional accounts.
Required Minimum Distributions
Once you reach age 70 1/2, you must start taking withdrawals from your IRAs or you will face a hefty tax penalty of up to 50 percent of the amount you failed to withdraw. These withdrawals are called required minimum distributions.
You can find out how much you need to withdraw based on your age and the amount of money in your accounts. You can use tables published by the IRS to compute the amount you must withdraw or use online calculator tools provided by financial news sites and brokerage sites. Your bank, brokerage, financial adviser or accountant can also potentially help you calculate your required minimum distributions.
Roth IRAs are not subject to required minimum distributions.
Make sure you understand and plan ahead for your required minimum distributions so that you can position your withdrawals into particular years to avoid putting yourself into a higher tax bracket.
SEP and SIMPLE IRAs
SEP and SIMPLE IRAs are types of employee pension plans that work similarly to traditional IRAs. You generally can't open a SEP or SIMPLE IRA for yourself. An exception is if you are self-employed and opening it for yourself as an employee.
- The Street: 401(k) and IRA Contribution Limits Boosted for 2019
- IRS: Publication 590-B (2018), Distributions from Individual Retirement Arrangements (IRAs)
- IRS: Publication 590-A (2018), Contributions to Individual Retirement Arrangements (IRAs)
- USAA: Compare IRAS For Self-Employed And Small Business Owners (SEP And SIMPLE)
- IRS: Rollovers of Retirement Plan and IRA Distributions
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.