Updated March 2024
Around early April, we get at least one or two incoming phone calls from people who want to set up and fund an IRA account right before the tax filing deadline because their CPA told them they needed one for tax purposes.
In the spirit of the season (and with the hope that you won’t wait until 24 hours before the deadline to act), I’m going to outline the what, why, and how of IRAs so you can decide now if you need one.
What is it?
IRA stands for Individual Retirement Arrangement – you thought the A was for Account didn’t you?!
An IRA is a retirement savings account that is associated only with an individual, unlike other common retirement accounts, such as a 401(k), which is associated with an employer. An IRA allows you to save for retirement by depositing money in a tax deferred account each year up to a specific limit. [1]
“An IRA allows an individual to save for retirement by depositing money in a tax deferred account.”
Once that money is deposited into the IRA, it can be held in cash or used to invest in a variety of securities like individual stocks, individual bonds, mutual funds, or exchange traded funds. Rules that apply to IRAs are dictated by the US tax code and as with any element of the U.S. tax code, there are some rules to know.
Let’s dive in by discussing the two primary types of IRAs: Traditional and Roth.
Traditional IRA
Most anyone with earned income can contribute to this type of IRA. For tax year 2024, the most you can contribute is $7,000[2], plus an additional $1,000 if you are age 50 or over.[3] Contributions are made using money that you’ve already paid income tax on. Once the money is in the account, any dividend income, interest income, or capital gains that would otherwise be taxable are not taxed until you begin taking money out of the account in retirement.
When you begin taking money out of the account it is taxed like ordinary income; similar to how your wages are taxed.
If your income is below a certain threshold, your Traditional IRA contribution may be tax deductible.[4]
Roth IRAs
Only certain people with earned income can contribute directly to a Roth IRA based on their income and filing status. For example: if you are married and filing a joint return, you can make a full $7,00 contribution for tax year 2024 only if your is less than $230,000[5].Check out all the limits and phase-outs here. As with Traditional IRAs, contributions are made with dollars that have already been taxed. Roth IRA contributions are never tax deductible.
So why bother? Unlike Traditional IRAs, where any earnings within the account are not taxable until withdrawn, with a Roth IRA, those earnings are never taxed – ever. Even when you take money out of your Roth IRA in retirement (assuming it is a qualified distribution), none of it is taxed.
This type of IRA also avoids Required Minimum Distributions during the account owner’s lifetime.
Why would I want an IRA?
The key benefits of an IRA are the tax goodies.
Sometimes you get tax goodies today (tax-deductible Traditional IRA contributions), tax goodies over time (tax deferral on investments gains and investment income in a Traditional IRA), or tax goodies tomorrow (tax-free investment gains and investment income in a Roth IRA).
This may feel abstract, so let’s do some simple math.
Deductible contributions
Let’s say you are married and file a joint return. Your modified adjusted gross income is less than $123,000, and both you and your spouse make $7,000 Traditional IRA contributions. You can now deduct $14,000 from your gross income to arrive at your adjusted gross income. Adjusted gross income drives your tax bill, so lowering this number can result in a lower tax bill.
But what if you earn too much to deduct?
Tax deferral
Regardless of your ability to deduct your contributions, you’ll still enjoy tax deferral on your IRA savings. For example, say you choose to invest your IRA money in shares of the well-diversified XYZ fund — during the year, XYZ fund zooms up 30%. Your $7,000 is now $9,100, and you want to take your profit and invest it in another security.
If you did this in a non-IRA account, your $9,100 would become only $8,785[6] because you’d owe capital gains taxes. In an IRA, there are no capital gains taxes due that year. This means two things: 1) your tax bill doesn’t go up that year due to selling XYZ fund, and 2) more of your money stays invested — which means more of your money is compounding.[7]
Over time, keeping those dollars working (instead of sending some of them to Uncle Sam) means you could have a bigger pot of money to enjoy in retirement on whatever it is that makes you happy. Tax deferral on your investments is like fertilizer for a garden – it helps things grow a little faster.
Read: How Do Taxes Work?
What’s the catch?
I’m glad you asked. IRAs come with some caveats that you need to be aware of before you make that first deposit.
- #1: In general, you can’t take money out of an IRA until you attain age 59½. If you take money out early (and you don’t qualify for an exception), you’ll be subject to a 10% penalty tax in addition to any income tax due.
- #2: You need to make some choices about what to own. Putting cash in an IRA and letting it just sit there uninvested somewhat defeats the purpose of the account.
- #3: The burden of record keeping is on you. If you make nondeductible contributions to a Traditional IRA, you need to track those on Form 8606 of your tax return. Why? Because if you’ve already paid taxes on those dollars (and got no deduction the year you contributed), you don’t want to pay taxes again when you withdraw the funds from your Traditional IRA. The IRS won’t keep track of this for you.
- #4: Traditional IRAs are subject to Required Minimum Distributions (RMD) once the account owner attains age 73 (age 75 beginning in 2033). At some point the tax deferral party will end, and Uncle Sam will demand his cut. Your annual RMD is calculated using this formula:
IRA Account Balance on December 31 of Prior Year = RMD
Uniform Lifetime Table Factor[8]
If you fail to take your annual RMD, you’ll be assessed a 25% penalty tax on the RMD amount.
Do I need one?
You probably do but it’s hard to know unless you’ve gone through the Financial Planning process to determine how much and where you need to save.
Most retirement savers need an IRA and many investors could benefit from having one. An IRA is powerful wealth building tool.
“It’s a powerful wealth-building tool.”
If you are a younger investor (I’m looking at you younger Millennials and Gen Z), opening an IRA now and funding it every year until you retire can set you up for exponential growth over time (see the compounding calculator in footnote 5).
Ready to make an IRA part of your Financial Plan?
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Robert W. Baird & Co. does not offer tax or legal advice.
[1] I want to take a moment to emphasize that if you don’t contribute to an IRA for a given tax year, you can’t ever go back and make up those missed contributions. Once the annual opportunity is gone, it’s gone forever.
[2] The limit for tax year 2023 is $6,500 plus the catch-up contribution if eligible
[3] This is known as a catch-up contribution.
[4] Consult your tax advisor to see if you qualify to deduct your Traditional IRA contributions.
[5] The upper limit is $218,000 for tax year 2023
[6] This assumes a 15% long-term capital gains tax rate and no state level taxes on the gain.
[7] You can learn all about compounding here – it’s a pretty big deal.
[8] Learn more about Required Minimum Distributions here.
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