Summary
- An Individual Retirement Account (IRA) is an investment account specifically for saving towards retirement that provides tax benefits.
- Traditional IRA has pre-tax contribution and tax-deferred growth benefits.
- Roth IRA has tax-deferred growth and tax-free withdrawal benefits.
- 2025 contribution maximum is $7,000 ($1,000 catch-up for 50+ years old).
As the name says, this is an Individual Retirement Account (IRA) which is an investment account for you to save towards retirement. There is no such thing as a joint IRA. I’ve been asked that many times and one of the consistencies I’ve found when it comes to anything investment related is that what seems self-explanatory never is and that’s OK. So, it’s an account just for you and only you. An interesting fact, according to the IRS, the ‘A’ stands for Arrangement and not the more commonly used Account. This “Account” is designed specifically for you to save money for the day when you stop working for good and need to turn it into an income stream. What makes retirement accounts so special is that they provide you with benefits that you can’t just receive anywhere. These are tax benefits that generally allow you to grow your money faster while paying less in taxes. How these tax benefits work in detail can be found here. We’re going to be talking about the 2 most widely used IRA’s even though there are others. These 2 are called a Traditional IRA and a Roth IRA.
Traditional IRA has tax benefits #1 (pre-tax contributions) and #2 (tax-deferred growth) from the linked article above. Let’s begin with money going into the account. To be able to contribute at all, you need earned income during the same year that you make the contribution for. Interest you’ve earned in your savings account, gains from investments, or someone gifting you money does not count. By earned income I mean that the IRS knows you made this money and it’s taxable. In case you were wondering, yes, that does mean a minor with a paper route or who mows your neighbor’s lawn can also contribute to an IRA. Make sure you abide by your state’s labor laws of course and keep a record of how the income was earned. When you make an IRA contribution, you use the money from your bank account to deposit into the IRA. Now follow me here on this. Money you earned from your paycheck that has been taxed already, goes into your bank account, and then goes from your bank account into the IRA. The question you should be asking now, if it’s taxed money I’m putting into the IRA, this IRA provides the pre-tax benefit, how is the money going in pre-tax?! This is a spot where a lot of confusion stems from. The answer is it’s not. It’s 100% money that has already been taxed. The next question is, how do you get money deposited into your IRA before it’s taxed? There is a way which I’ll touch on towards the end but it’s a different type of IRA than the 2 we’re talking about now. Remember the tax refund I said I prefer not to get? That’s where you get it from. If you’re putting money that has already been taxed into a Traditional IRA, the IRS gives those taxes back to you in the form of a refund when you file your taxes the following year. To sidebar slightly on this topic, situations like this are why I prefer not getting a refund. For most people, your refund is primarily due to excess money withheld from your paycheck for taxes throughout the year. The W-4 you filled out with your employer will determine what your tax withholding is. If you’re getting a large refund every year, for most people, you’re having too much withheld from your paycheck. You may also have a lot of deductions/credits too. You can update your W-4 at any time if you want to adjust and there’s calculators online to help you with this. My preference is to have that money now to do something else more productive with it, but that’s just me. Anyway, back to the topic… You get the pre-tax benefit because the IRS eventually returns the taxes that you already paid on the money you contributed to your Traditional IRA. Now that you’re putting money into a Traditional IRA, how much can you put in? It’s a great question, however it’s more complicated than you’d think because the IRS always has additional rules with exceptions. There is a maximum you can put in every year. I have a page that shows current tax information which you can find here. For 2025, that amount is $7,000. That’s the easy part but here’s a wrench to throw into the gears. You can always contribute to a Traditional IRA, however whether you receive the pre-tax benefit or not depends on a couple of items. Those are your annual income and if you’re covered by a retirement plan through your employer. If you have an employer plan and make over $87,000 MAGI (modified adjusted gross income) a year filing as a single person, the IRS says you cannot receive the pre-tax benefit. You can get these exact benefits from a retirement plan provided through your employer, so the IRS is not letting you get extra benefits after exceeding a specific income amount. However, if you make $77,000 MAGI or less while covered by an employer plan you can still receive the full tax benefit. There is a gap there on purpose and it’s called the “phase out.” If your MAGI is between $77,000 – $87,000, you’ll receive partial pre-tax benefits for your contributions. He’s how to determine what the partial benefit is. Take the top end of the range, minus your MAGI, divide by the range’s difference. So that’s $87,000 minus your MAGI and divide by $10,000. Use that percentage, multiply it by your contribution amount, and that’s how much of your contribution you’ll receive the pre-tax benefit on. If you don’t have a retirement plan through your employer, then there are no income restrictions for receiving the pre-tax benefit. Again, that’s if you’re filing taxes as a single person. It’s never simple with the IRS so these income limitations and phase outs are different for other marital statuses which you can find in the Tax Facts. Moving onto tax benefit #2, tax-deferred growth, fortunately it’s just that simple. Your money grows without paying taxes on it. Unlike an interest-bearing bank account where you pay taxes on the interest earned every year (only if that interest exceeds a certain amount). An IRA, you can grow it limitlessly and not pay any taxes on it until the day comes when you need to take the money out. With a Traditional IRA, money goes in without paying taxes and it grows without paying taxes. Where you pay the taxes is when you take it out. The IRS always gets their money at some point and in this case, they just get their money when you’re older instead of today.
Roth IRA has tax benefits #2 (tax-deferred growth) and #3 (tax-free withdrawals). The Roth IRA came into existence in 1998, named after Delaware Senator William Roth. This type of IRA typically attracts more attention because of how the tax benefits work. Just as before, you’re depositing money from your bank into the IRA. This time, you’re not receiving the pre-tax benefit on purpose. Instead, you receive a tax benefit on the other end when you take the money out. That tax benefit is called tax-free withdrawals. Combine that with the second tax benefit of tax-deferred growth and you’ll find that you pay taxes on the way in only but not on the way out. Essentially, what you’re doing is removing your money from the tax system altogether. Meaning that, once the money goes in, no matter how much that money grows for you, you never have to pay taxes on it again. The Roth does have a phase out as well but it’s much more simplistic than the Traditional IRA. The income range for phase out is higher, between $138,000 – $153,000 for a single filing person. Unlike the Traditional IRA where you can always contribute regardless of whether you get the pre-tax benefit or not, the IRS says here you’re not allowed to contribute at all if your income is over this range. In fact, they penalize you if you contribute when your income is over the phase out. If you end up doing this, there are ways to rectify it without penalties. However, if you do not correct it, you will pay a 6% penalty on excess contribution amount per year until it has been fixed. The math for the phase out calculation is basically the same as the Traditional IRA. You’ll take $153,000, subtract your MAGI, and divide it by $15,000. Where it differs is here, because you’ll multiply that percentage by the tax year’s maximum contribution amount of $7,000 and the answer is what you’re allowed to contribute. As I mentioned earlier, the Roth attracts more attention because it allows for tax-free withdrawals, which most people think of as the superior option. That’s not always the case and it depends on your situation. Please don’t listen to TV hosts that tell you which one is better for you. It’s all their opinion, they don’t know you, or the financial position in life. Always discuss these matters with a trusted financial professional to determine which is the best for you. Another day, I’ll type a post on the math behind both strategies and it will blow your mind!
As we wrap this up, here are additional considerations you need to know. You can have as many IRA’s opened as you’d like, it doesn’t matter if it’s a Traditional or Roth, however you cannot exceed the annual contribution maximum combined with all your accounts. For example, if you have 2 IRA’s, you cannot contribute $7,000 each totaling $14,000. You can do $3,500 each, or $3,000 and $4,000, or any other combination totaling $7,000. You just can’t put the maximum into every account you have opened. A fantastic feature that you can utilize is being able to make contributions up until you file your taxes the following year. Meaning, if you didn’t contribute to an IRA during the 2024 calendar year, you can still do so up until you file your taxes even though it’s already 2025. Where this comes in handy is if you’re not sure your income will exceed the phase out limit. You can simply wait until the following year to contribute when you know exactly what your income was the prior year. It’s very common and simple to set up systematic monthly contributions into an IRA from your bank account. It helps mimic deductions from your paycheck, and you won’t forget to make your contributions. Speaking of paycheck deductions, earlier I said I would talk about this very thing later and here it is. Your employer can set up a Payroll Deduction Traditional or Roth IRA for you if they choose to offer it. This is the only way you can have money deposited into your IRA directly from your paycheck without it going to your bank account first. An employer offering any type of retirement plan is never required by the way, but you’ll find most do because they want to stay competitive in the hiring market. Down the road you’ll need to know about Required Minimum Distributions (RMD’s) which will apply to the Traditional IRA only and not the Roth IRA. The short of it is you’ll be required to withdraw money from your Traditional IRA at a certain age even if you don’t want or need to. If there weren’t enough rules already, here is one that applies to all types of retirement accounts and is extremely important to know. Retirement accounts are meant to be used for exactly that. The IRS imposes penalties if you want to access your money in a retirement account prior to what they say is retirement age which is 59.5. You may also have to pay taxes on it too in addition to the penalties. Do you have to wait until 59.5 to withdraw money for any IRA or any retirement account? No, you do not. This is your money, you always have access to it, whether you pay a penalty or not is another question. But wait, there’s more! This is turning into an infomercial now with all these additional rules and exceptions. There are exceptions to accessing your retirement funds prior to age 59.5 without penalty. I won’t go into what those are but just know they exist. Ideally, you don’t need to use it for any of them. Finally, to decide which one is better for you is another conversation. The most important thing is that you contribute regardless of which one you choose. The tax benefits you receive from either will monumentally help you accumulate assets for retirement. It’s never too early to start saving for retirement but there’s definitely a time when it’s too late.
