IRA

From Bogleheads

An individual retirement arrangement, or IRA, is a personal savings plan which allows you to set aside money for retirement, while offering you tax advantages. You may be able to deduct some or all of your contributions to your IRA. Amounts in your IRA, including earnings, generally are not taxed until distributed to you. IRA's cannot be owned jointly. However, any amounts remaining in your IRA upon your death can be paid to your beneficiary or beneficiaries.

You can open an IRA at a bank or other financial institution or with a mutual fund or life insurance company. You can also open an IRA through your stockbroker. Any IRA must meet Internal Revenue Code requirements.[1]

ICI (Investment Company Institute) reports that at year end 2018, Traditional IRA's held an estimated $8.806 trillion of investor's wealth accounting for 85% of total IRA assets.[2][note 1]

Overview

There are three types of IRAs.[3]

  1. Individual retirement account: A trust created or organized in the US for the exclusive benefit of an individual or his beneficiaries.
  2. Individual retirement annuity: An annuity contract or an endowment contract issued by an insurance company.
  3. Accounts established by employers and certain associations of employees: A trust created or organized in the US by an employer for the exclusive benefit of his employees or their beneficiaries, or by an association of employees for the exclusive benefit of its members or their beneficiaries. Examples include SEP, SARSEP, and SIMPLE IRAs. See: Employer retirement plans overview.

Traditional IRA

A traditional IRA can be an individual retirement account or an annuity. It can be part of either a SEP (Simplified Employee Pension) or an employer or employee association trust account.[4]

The traditional IRA was created in 1974 with the passage of the Employee Retirement Income Security Act (ERISA).[note 2] Over the years, the Traditional IRA has been expanded to include a growing number of specialized plan types. These include the following:

Type of IRA Description
Traditional IRA Original type of IRA. Allows tax-deductible contributions, subject to income limitations, and offers tax-deferred growth. Withdrawals are taxable, except for return of basis, which is "pro-rata."
Roth IRA Contributions are after-tax but all future growth and withdrawals are tax-free. Contributions are subject to income limits. Shares a contribution limit with the Traditional IRA.
SEP (Simplified Employee Pension) IRAs Retirement plan for self-employed individuals with no employees, and a simpler alternative to the Solo 401(k). Contributions are tax-deductible, growth is tax-deferred, and withdrawals are taxable. Contribution limit is independent from Traditional and Roth IRAs.
SIMPLE IRAs Retirement plan for small businesses with employees, and a simpler alternative to the 401(k). Its use excludes the use of any other employer retirement plan, including the SEP-IRA. Employer matching is permitted. Contributions are tax-deductible, growth is tax-deferred, and withdrawals are taxable. Contribution limit is independent from Traditional and Roth IRAs.

Your contribution to an IRA is limited by the amount of compensation you receive during the year. Compensation includes wages, salaries, etc., commissions, self-employment income, taxable alimony and separate maintenance, nontaxable combat pay, taxable non-tuition fellowship and stipend payments.[5]

See Roth versus Traditional for more guidance on how to choose between pre-tax and Roth contributions.

Individual retirement annuity

You can open an individual retirement annuity by purchasing an annuity contract or an endowment contract from a life insurance company.[4]

An individual retirement annuity must be issued in your name as the owner, and either you or your beneficiaries who survive you are the only ones who can receive the benefits or payments.[4]

Annuities may follow different rules than an individual retirement account. For example, special rules apply to figuring the required minimum distribution.[note 3] Refer to IRS Publications 590-A and 590-B for guidance.

You can use the money in your traditional IRA account to buy an annuity contract. You aren't taxed when you receive the annuity contract (unless the annuity contract is being converted to an annuity held by a Roth IRA). You are taxed when you start receiving payments under that annuity contract. See IRS Publication 590-B for tax calculations regarding deductible and non-deductible contributions.[7]

Other IRA terminology

In addition, various terms are used to describe specific types of IRAs that fit into the above categories, but have special rules and specific legal implications. These terms include:

Type of IRA Description
Inherited IRA Inherited IRAs can be either Traditional or Roth, and Traditional IRAs inherit the basis of the original IRA. Inherited IRAs work like normal IRAs, but cannot be commingled with or rolled into other IRAs, cannot receive contributions from the new owner, and Traditional Inherited IRAs cannot be converted to a Roth IRA. Inherited IRAs have special distribution requirements; see: Required Minimum Distribution.
Stretch IRA IRAs inherited prior to January 1, 2020 can be kept (and "stretched" out) over the heir's life expectancy, providing long-term tax-deferred or tax-free growth. RMDs are required every year regardless of the heir's age, although they should be smaller than the rate of return of reasonable investments until the heir is well into their 70's, so the balance could continue to grow for decades. Following the passage of the SECURE Act, IRAs inherited after January 1, 2020 (with several exceptions[8]) have no RMDs, although must be emptied by the end of the tenth year after being inherited. It remains to be seen whether these will be commonly referred to "Stretch IRAs" too.
Rollover IRA A Rollover IRA is created when the account holder rolls over funds from a qualified retirement plan into an IRA, and they can be either Traditional or Roth. While Rollover IRAs generally work like normal IRAs, some employer plans limit incoming rollovers to Rollover IRAs and exclude Contributory IRAs, so contributing to a Rollover IRA could preclude a future rollover into these plans. Can also have legal consequences related to asset protection.
Contributory IRA A Contributory IRA is an IRA into which the account holder has directly contributed. Some employer plans prohibit incoming rollovers from Contributory IRAs. Can also have legal consequences related to asset protection.
Spousal IRA If you file a joint return, you may be able to contribute to an IRA even if you didn’t have taxable compensation as long as your spouse did. Each spouse can make a contribution up to the current limit; however, the total of your combined contributions can’t be more than the taxable compensation reported on your joint return. See the Kay Bailey Hutchison Spousal IRA Limit in Publication 590-A.[9]
Non-deductible IRA A "Non-deductible Traditional IRA" or "Non-deductible IRA" is a Traditional IRA to which after-tax contributions have been made. Inherited, Contributory, and Spousal Traditional IRAs can all be non-deductible. The Traditional IRA page discusses the mechanics of basis tracking and withdrawals, and the main page discusses suitability and performance of non-deductible IRAs.
Self-directed IRA or "Checkbook" IRA Self-Directed IRAs can be either Traditional or Roth, and allow for a much wider range of investments than would normally be permitted in an IRA; see below.

Allowable investments

IRAs available with most custodians allow a wide range of publicly-available investments, such as: stocks, bonds, mutual funds, savings accounts, money market accounts, Certificates of Deposit (CDs), Treasury Inflation-Protected Securities (TIPS), and Real Estate Investment Trusts (REITs).

If you wish to purchase an annuity with money in your traditional IRA account, do a direct rollover to an Individual Retirement Annuity to avoid a taxable event. Annuities funded with an IRA rollover are "qualified" plans, enabling an insurance company to create an "IRA annuity", into which you can deposit your retirement funds directly.[10] This is typically done with an immediate annuity such as a Single Premium Immediate Annuity (SPIA) in the distribution phase.[note 4]

Some IRA custodians offer "Self-directed" or "Checkbook" IRAs that allow an even wider range of investments, including: IPO stock, privately-owned businesses, loans (mortgages, hard money loans, etc.), domestic or foreign real estate (including undeveloped land), private real estate funds or syndications, certain derivatives (including stock options), foreign currencies, tax liens, and others. These IRAs usually have additional fees to cover the higher management costs for these investments.

Prohibited investments and transactions

Regardless of whether an IRA is self-directed, the following types of investments and transactions are prohibited:

  • Collectibles (artwork, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, etc.), except for:
    • 1 oz, ½ oz, ¼ oz, or 1/10 oz US gold coins
    • 1 oz silver coins minted by the US Treasury Department
    • Certain platinum coins
    • Certain gold, silver, platinum, and palladium bullion
  • Life insurance contracts
  • Certain types of derivatives
  • Self-dealing transactions involving yourself, your family, or your beneficiary, including:
    • Loans to yourself or other disqualified persons
    • Personally using property purchased with IRA funds, including real estate
    • Acting as a property manager or performing maintenance on an IRA-owned rental property

Required Minimum Distributions

Traditional, SEP, and SIMPLE IRAs have Required Minimum Distributions that generally begin the year the account holder reaches age 72. See the main page for a discussion of the details.

Inherited IRAs (Traditional and Roth) inherited prior to January 1, 2020 have Required Minimum Distributions calculated by IRS Publication 590-B Distribution Table I. Inherited IRAs (Traditional and Roth) inherited after January 1, 2020 have no RMDs, but must be emptied by the end of the tenth year after being inherited, unless certain exceptions apply.

Roth IRAs have no RMDs.

Comparison to employer accounts

Traditional and Roth IRAs have many similarities with employer retirement plans: contributions are either pre-tax (traditional) or Roth, growth is tax-deferred or tax-free, withdrawals before age 59½ are penalized unless exceptions apply, and are subject to RMDs (except the Roth IRA). However, IRAs are individually-controlled accounts, and employer plans are governed by the plan rules set by the employer and the provider, and they can have important differences. Many investors will face a choice between investing in an IRA and an employer plan, such as when not contributing enough to reach the limit in both accounts, and/or when separating from an employer and deciding whether to leave investments in the existing plan or roll it into an IRA. The following table lists the differences between IRAs, 401(k)'s, and 403(b)'s (the most common employer retirement account) that should help investors choose the best account given their own personal situation. This comparison is mostly independent of the choice between Traditional versus Roth tax structures, which is a complex topic discussed on its own wiki page. Other employer plans, such as the 457(b), have important differences, and those differences are discussed on their respective plan pages.

Comparison between IRAs and common employer plans
Feature IRA 401(k) (and 403(b)) employer plans Advantage
Contribution limits $7,000 ($8,000 for age 50+) combined for all Traditional IRAs and Roth IRAs. Spousal and gift contributions permitted.[note 5] $23,000 ($30,500 for age 50+) elective deferral for all employer retirement accounts. $69,000 ($76,500 including catch-up) total employee and employer contributions into each unrelated employer plan. No spousal contributions permitted. Some plans may offer after-tax contribution options as well. (403(b)'s may offer an additional catch-up contribution of up to $3,000 and with a lifetime maximum of $15,000, for employees with at least 15 years of service and who have averaged less than $5,000 annual contributions. 403(b) contributions are independent from limits to a 457(b).) While employer plans have higher contribution limits, this is not a good reason to not invest money first into an IRA, and/or roll over money from an employer plan into an IRA, if it were otherwise the preferred account.
Income limits Deducting Traditional IRA contributions has a low income limit when one is covered by a retirement plan at work. The limit is higher for spouses not covered, and there is no limit if the single filer or both MFJ filers are not covered. Roth IRA contributions have a higher limit, and this limit can be circumvented by the Backdoor Roth IRA process. Generally no income limits for 401(k) and 403(b) contributions, although there is a limit on the compensation that can be used for matching calculations ($345,000 as of 2024[11]) Employer plan
Available tax structures Traditional and Roth IRAs are always available, although deductible Traditional contributions may be prohibited by income. Roth is available to nearly all investors by direct contribution or use of the Backdoor Roth IRA process. Traditional contributions are always available, but Roth is only available if the plan allows it. Plans that allow after-tax contributions and either in-plan Roth rollovers or in-service distributions can be used to make mega-backdoor Roth contributions up to the Section 415 limit ($69,000 for 2024). Depends on the employer plan and the investor's income.
Roth conversions Traditional IRAs always allow Roth conversions to a Roth IRA. Roth conversions are only possible from an employer plan while the employee is working if the plan offers either In-Service Withdrawals (which allow rollover to a Roth IRA), or a Roth sub account and in-plan Roth rollovers. Investors can always roll money out of an employer plan (into a Traditional or Roth IRA) when they separate from their employer, which is a more common situation for wanting to do Roth conversions. Although not common, employees who may want Roth conversions while working should keep some pre-tax money in a Traditional IRA if their employer plan does not allow Roth conversions.
Employer contributions and matching IRAs are individual accounts, and have no matching with the exception of a SIMPLE IRA. Some employer plans offer employer matching contributions, usually 50% or 100% up to some limit. Solo 401(k)'s allow large employer contributions, which effectively raises the contribution limit for the self-employed. Employer plan, if matching is offered. Getting an employer match should be a top financial priority.
Investment choices IRAs allow a wide range of investments, and this can be expanded further with a Self-directed IRA. Employer plans only allow a set of investments offered by the plan, which may be undesirable. Some plans have a brokerage option allowing trading of stocks and ETFs, and occasionally a plan will have unusual investments (a stable value fund, annuities, real estate funds, etc.) that could be uniquely valuable to certain investors. For the self-employed, Solo 401(k)'s are available at no cost and with a similarly wide range of investment choices as an IRA, and Self-directed Solo 401(k)'s are available that are similar to Self-directed IRAs. IRA when compared to most employer plans, and a tie compared to a Solo 401(k). Exceptions exist.
Unrelated Business Income Tax (UBIT) IRAs are only tax-deferred or tax-free for passive investments. If a (usually self-directed) IRA invests in an active business that does not pay corporate taxes, such as an LLC, partnership, or S-corporation, the IRA must pay UBIT on the active income. UBIT also applies to house-flipping, which is considered active income. IRAs must also pay UBIT on Unrelated Debt Financed Income (UDFI), income on a debt-financed investment (eg. rental property) inside an IRA. UBIT receives a $1,000 standard deduction and is paid by the IRA according to the trust tax brackets. Self-directed Solo 401k's are subject to the same UBIT rules as IRAs. However, they are not subject to Unrelated Debt Financed Income (UDFI) on leveraged real estate investments. Investors looking to invest in leveraged real estate should prefer a self-directed Solo 401(k) to a self-directed IRA
Fees IRAs are available from many custodians for no cost and only the expenses within investments (~0.1% per year or less). Employer plans can have much higher fees (~1-2%+ per year) than IRAs. However, employer plan fees have come down on average in recent decades, and many are competitive with IRAs. Some plans offer "institutional class" or other funds with even lower expenses than similar funds in a retail IRA. Usually the IRA, although exceptional employer plans are slightly better than IRAs.
Compatibility with Backdoor Roth IRA Pre-tax Traditional (along with SEP and SIMPLE) IRA balances interfere with the Backdoor Roth IRA 401(k) and 403(b) balances do not interfere with the Backdoor Roth IRA. Major advantage to the employer plan for pre-tax money for those wishing to make Backdoor Roth IRA contributions.
Early (before age 59½) distribution options Exceptions to the age 59½ rule: disability, education expenses, SEPP, first-time homebuyers (up to $10,000), IRS levy, medical expenses, unemployed health insurance premiums.[12] Roth IRAs also allow withdrawal of contributions at any time without penalty, which allows great flexibility. Exceptions to the age 59½ rule: disability, SEPP, IRS levy, medical expenses, separation from service age 55 or older.[12] Plans may offer hardship withdrawals and/or in-service withdrawals, but whether these withdrawals incur penalties is subject to IRS rules. Some plans also allow loans to the participant. Employer plans are allowed to involuntarily roll small ($1,000-5,000) balances into an IRA upon separation, and cash out very small (<$1,000) balances, possibly generating taxes and penalties unless the owner takes positive steps to roll the balance into an IRA. The Roth IRA has a major advantage over all other retirement accounts. Otherwise, close to a tie; it depends on the plan options and the situation.
Asset protection[note 6] IRAs receive state-level protection from civil judgments, which varies widely by state. Traditional and Roth IRAs are exempt from federal bankruptcy up to $1.0M, and SEP and SIMPLE IRAs receive unlimited exemption. Can be divided in a "transfer incident to a divorce." ERISA 401(k) and 403(b) plans are protected from civil judgments and bankruptcy at the federal level. Solo 401(k)'s are generally not ERISA plans, and receive state-level protection similar to IRAs. Can be accessed by a Qualified Domestic Relations Order (QDRO). (Not all 403(b)'s are ERISA plans.) Highly dependent on the state. ERISA employer plans may have an advantage over IRAs. Solo 401(k)'s are about equal to IRAs.
Required Minimum Distributions Traditional IRAs generally require RMDs starting at age 73. Roth IRAs have no RMDs. Traditional 401(k)'s and 403(b)'s require RMDs at age 73, but they are waived if you are still working. Roth 401(k)'s and 403(b)'s have no RMDs . Traditional Solo 401(k)'s start RMDs at age 73 regardless of whether you're still working. Traditional employer plans have an advantage for those working after age 73 and looking to avoid RMDs. Otherwise, close to a tie.
Inheritance When inheriting an IRA, spouses generally have the option to (1) treat the IRA as their own, (2) roll the IRA into their own IRA or into an employer plan, (3) treat the IRA as an Inherited IRA, (4) cash out the IRA with whatever tax liability results, or (5) disclaim the IRA and let it pass to the contingent beneficiary. Non-spouses must treat the IRA as an inherited IRA, which has distribution requirements. Spouses generally have the same options as they would inheriting an IRA. Some employer plans allow beneficiaries to leave the balance in the plan, and take RMDs like an IRA. Otherwise, the balance is rolled out into the appropriate type of inherited IRA. Tie

Notes

  1. Traditional IRA assets 1997 - 2018 (in billions). Source: Investment Company Institute Factbooks.
    • Share is the percentage of total IRA assets.
    • Traditional IRAs include contributory and rollover IRAs.
    • ᵉ Data are estimated.

    Sources: Investment Company Institute, Internal Revenue Service Statistics of Income Division, and Government Accountability Office

  2. See "The Individual Retirement Account at Age 30: A Retrospective" (PDF). Perspective, V11, N1. Investment Company Institute. February 2005. Retrieved March 14, 2017. for a history of the Traditional IRA to 2003.
  3. Special rules apply if you receive distributions from your traditional IRA as an annuity purchased from an insurance company. See Regulations sections 1.401(a)(9)-6 and 54.4974-2. These regulations can be found in many libraries, and IRS offices, and online at IRS.gov.[6]
  4. The tax benefits of acquiring a deferred Variable Annuity with non-qualified money (taxes already paid) would be wasted inside an IRA because taxes are paid when withdrawn. You would be paying tax on this money twice. Qualified vs. Non-Qualified Annuities, from Annuity.org, provides definitions and background information.
  5. In addition to a spouse, any individual may contribute to an IRA. "§408. Individual retirement accounts". Office of the Law Revision Counsel of the US House of Representatives. 26 USC §408(a)(1). Retrieved February 22, 2022. will not be accepted for the taxable year on behalf of any individual. "on behalf of" suggests that anyone may contribute.
  6. Asset protection is a complex legal subject that is further complicated due to many laws being state-specific. The information presented here is only high-level, and as noted on the wiki page, legal ambiguity exists in some areas. For asset protection legal advice, consult a competent asset protection attorney in your state.

See also

References

  1. "IRS Pub 590-A Contributions to Individual Retirement Arrangements (IRAs)" (pdf). IRS. p. 6. Retrieved 12 March 2020.
  2. 2019 ICI Mutual Fund Fact Book:The U.S. Retirement Market
  3. "Individual retirement accounts". 26 USC §408. Office of the Law Revision Counsel of the US House of Representatives. Retrieved July 22, 2021.
  4. 4.0 4.1 4.2 "Publication 590-A (2020), Contributions to Individual Retirement Arrangements (IRAs)". Internal Revenue Service. March 5, 2021. Retrieved July 23, 2021.
  5. "Publication 590-A (2021), Contributions to Individual Retirement Arrangements (IRAs)". Internal Revenue Service. "Who Can Open a Traditional IRA?" and Table 1-1. Retrieved February 19, 2022.
  6. "Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs)". Annuity distributions from an insurance company. Internal Revenue Service. May 25, 2021. Retrieved July 23, 2021.
  7. "Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs)". Distribution of an annuity contract from your IRA account. Internal Revenue Service. May 25, 2021. Retrieved July 23, 2021.
  8. The (Partial) Death Of The Stretch IRA: How The SECURE Act Impacts Inherited Retirement Accounts, Michael Kitces, February 12, 2020.
  9. "Retirement Topics - IRA Contribution Limits". Internal Revenue Service. September 22, 2022. Retrieved October 11, 2022.
  10. "Can I Buy An Annuity With My IRA or 401k?". ImmediateAnnuities.com. June 21, 2021. Retrieved July 23, 2021.
  11. 401-k plans deferrals and matching when compensation exceeds the annual limit, IRS
  12. 12.0 12.1 Tax on early distributions, IRS

External links

IRS

Bibliography