Comprehensive Guide to Understanding IRAs

An Individual Retirement Account (IRA) is a kind of retirement account that offers tax benefits that not only encourage savings, but also amplifies the power of every saved dollar.
 

You want to create a retirement savings plan that meets your current and future needs and helps your hard-earned dollars go the farthest. However, retirement planning can be complicated. Understanding all the terms, tax implications, and rules can be challenging when trying to choose the right account.

While working with a professional wealth manager is always essential, it’s also good for you to understand the fundamentals, from the key differences between Traditional IRAs and Roth IRAs to general contribution limits and withdrawal rules. In this guide, we’ll explore the ins and outs of IRAs, how to utilize them as part of your retirement plan, and how to make the most of the tax advantages they offer. First, let’s start with the basics. 

What is an IRA?

An Individual Retirement Account (IRA) is a retirement account that offers tax benefits which encourages saving and amplifies the power of every saved dollar. Unlike 401(k)s and other employer-sponsored plans, these plans can be opened by individuals to save for retirement, either as a stand-alone plan or in addition to other retirement savings, subject to certain limitations in the tax code.

The framework of IRAs was introduced by the Employee Retirement Income Security Act (ERISA) in 1974, and taxpayers were allowed to contribute the following year. Initially designed for individuals who did not have access to employer-sponsored retirement plans, IRAs offered these individuals a way to save independently for retirement. By the 1980s, IRAs were available to those who did not have access to employer-sponsored retirement plans and even those with employer-sponsored pensions as long as they were not disqualified from contributing due to their income levels.

When it comes to taxability, there are two main kinds of IRAs—traditional IRAs and Roth IRAs—each offering distinct advantages. Let’s take a closer look at them so you can decide which one may work best for you.

What is a Traditional IRA?

A traditional IRA is a retirement savings account that lets you contribute pre-tax—or deduct your contributions from your taxable income. Traditional IRAs also grow tax-deferred (until they are withdrawn in retirement). In other words, you don’t pay taxes on your account’s growth, but you’ll pay taxes on the money you withdraw in your retirement.

Eligibility and Contribution Limits

There aren’t many restrictions on eligibility for traditional IRAs, but there are some rules around how much and when you can contribute. 

• Income requirements: Most individuals with earned income are eligible to contribute to a traditional IRA, regardless of their income level. However, if you or your spouse have a retirement plan at work, you might not be able to take the full deduction. The IRS outlines these details.
• Age: As of 2020, contributions can be made at any age if the individual has earned income. Individuals cannot withdraw from the account without facing a penalty (10%) until age 59 ½ and must make withdrawals by age 73.
• Contribution limits: In 2024, the maximum contribution limit for a traditional IRA is $7,000 per year (or $8,000 for those aged 50 and older). This limit often increases annually, so take the time to check for the current year’s limit.
• Deadline: Contributions must be made by the tax filing deadline (usually April 15) for the prior tax year. For instance, contributions for 2024 can be made up until the tax filing deadline in April 2025.

How taxes work.

The tax advantages and requirements of IRAs can be challenging to navigate—that’s why working with an experienced wealth manager or retirement planner is important. However, here are the basic tax concepts to keep in mind about traditional IRAs:

• Deductions on contributions: Contributions to a traditional IRA are either tax-deductible (reduce your tax burden) or made with pre-tax dollars. The deduction amount depends on your income and whether an employer retirement plan covers you or your spouse.
• Taxes on earnings: You won’t pay any taxes on interest, dividends, or capital gains as long as the money remains in the account—only on your withdrawals.
• Taxes on withdrawals: Withdrawals (also known as distributions) are taxed as regular income if taken after age 59 ½.
• Early withdrawal penalty: Withdrawals taken before age 59½ are subject to ordinary income tax and a 10% early withdrawal penalty paid to the IRS. However, exceptions exist, such as first-time home purchases, qualified education expenses, or disability.
• Required Minimum Distributions (RMDs): Must begin making withdrawals by age 73.

Because you don’t pay taxes on contributions to a traditional IRA until retirement, they are ideal for individuals who want to reduce their tax burden in the near term but are less concerned about taxes in the future. 

What is a Roth IRA?

A Roth IRA is an IRA that offers tax-free growth (like a traditional IRA) and tax-free withdrawals in retirement (unlike a traditional IRA, whose withdrawals are taxed). Contributions to a Roth IRA are made with after-tax dollars, meaning they are not tax-deductible or tax-exempt (also unlike a traditional IRA).
Here's how a Roth IRA works in terms of eligibility, contribution limits, and taxes.

Eligibility and Contribution Limits

• Income Requirements: Different from a traditional IRA, there are caps on income with Roth IRAs, so it’s important to check with your accountant to make sure you qualify. You can also visit the IRS website for annual contribution limits.
• Age: As of 2020, contributions can be made at any age, as long as the individual has earned income. Individuals cannot withdraw from the account without facing a penalty (10%) until age 59 ½.
• Contribution limits: In 2024, the maximum contribution limit to a Roth IRA is $7,000 per year (or $8,000 for those aged 50 and older). 
• Deadline: Contributions must be made by the tax filing deadline (usually April 15) for the prior tax year.

How taxes work.

Here are the basic tax concepts to keep in mind about Roth IRAs:

• Deductions on contributions: Contributions to a Roth IRA are made with after-tax dollars, meaning they are not tax-deductible. Since you've already paid taxes on the money you contribute, you won’t pay taxes on it again when you withdraw it in retirement.
• Taxes on earnings: The growth of investments within the Roth IRA (interest, dividends, and capital gains) is tax-free.
• Taxes on withdrawals: Qualified withdrawals from a Roth IRA are completely tax-free if you are at least 59½ years old and you’ve held the account for at least five years.
• Early withdrawal penalty: Withdrawals taken before age 59½ are subject to a 10% early withdrawal penalty paid to the IRS, and you may have taxes on the earnings. However, certain exceptions exist, such as first-time home purchases, qualified education expenses, or disability.
• Required Minimum Distributions (RMDs): Unlike Traditional IRAs, Roth IRAs do not require you to take distributions at any age. 

Because you can leave the money in the account for as long as you want and will not pay taxes on withdrawals, Roth IRAs make a good option for wealth transfer to your heirs (more on this later), as well as tax-free income later in life—useful if you expect your income to be higher in retirement.  

Roth IRA vs. Traditional IRA

Sometimes, it may be hard to keep these two similar but differently structured retirement plans straight. And sometimes, it’s hard to know which makes the most financial sense for you.

The main difference between a Traditional IRA and a Roth IRA is that a Traditional IRA is taxed after growth at withdrawal, and Roth IRAs are taxed before growth. Because Roth IRAs usually have no taxes at withdrawal in retirement, there are some income restrictions for contributions. Let’s compare these two IRA options using current figures for the 2024 tax season.
 

Options	Traditional IRA	Roth IRA
Tax Deductible Contributions?	YES	NO
Tax-Free Growth?	No	$161,000 Single, $241,000 Married Filing Jointly
Annual Contribution Limits?	$7,000 ($8,000 if over 59 ½)	$7,000 ($8,000 if over 59 ½)
Tax-Free Withdrawals in Retirement?	No	Yes

Not sure which one makes the most sense for you? Use our Traditional vs. Roth Calculator. Though designed for 401(k)s, the tax implications will be similar. 

Roth Conversions: Converting a Traditional IRA or 401(k) to a Roth IRA

Moving funds from a traditional IRA, 401(k), or other pre-tax retirement account into a Roth IRA, is often called a “Roth conversion.” The amount you transfer is treated as taxable income that year (since you didn’t pay taxes on it when you contributed to the traditional IRA/401(k), but future withdrawals from the Roth IRA in retirement are tax-free. Something to note is that a Roth conversion is typically accomplished by converting a Traditional IRA to a Roth IRA with the same firm, broker, or recordkeeper.

Generally, there are two types of conversions:

• Direct Rollover: Funds are moved directly from the traditional IRA (or other retirement account) to the Roth IRA. You do not handle the money yourself, other than setting up the transfer, and there is never a time when money isn’t in one account or another. This method avoids any potential penalties or withholding taxes and is often the best option—if it is an option for your situation.
• 60-Day Rollover: You withdraw the funds from your traditional IRA. You then have up to 60 days to deposit them into a Roth IRA. However, if you miss the deadline, the distribution is treated as taxable income and may incur significant penalties.

When does a Roth Conversion make sense?

Sometimes, when we open an account or begin our retirement savings, we don’t have a clear picture of what our financial future looks like. If things change, your ideal retirement vehicle may change, too. 

Here are a few reasons why you might want to convert your traditional retirement account:

• Changing tax bracket: If you are in a lower tax bracket in the year of conversion but will likely be in a higher bracket in the future, a Roth conversion can help you pay taxes at a lower rate now and enjoy tax-free withdrawals in retirement.
• Want to avoid required distributions: Roth IRAs do not have required minimum distributions. If you don’t think you’ll need the regular income from your IRA in retirement, it can allow your savings to grow tax-free for longer. You can still use the funds as needed.
• Planning for the next generation: Roth IRAs are a better vehicle for passing wealth to heirs because the distributions are tax-free.

It’s important to keep in mind that the immediate tax burden when converting a traditional IRA can outweigh the long-term benefits in certain situations. Consulting with a wealth manager or retirement planner can help you evaluate your individual financial goals, tax situation, and retirement plans.

401(k) Rollovers: Transferring Funds to an IRA

If you have a 401(k), 403(b), or other similar account through an employer, it is possible to move those funds into an IRA. 401(k) rollovers are common when individuals change jobs. However, you might also consider whether you want more investment flexibility or access to different types of assets.

When does it make sense to consider a 401(k) Rollover?

401(k)s are often simple, automated, and tied to individual employers. Reasons you might choose to convert a 401(k) rollover to an IRA include:

• Tailored investment options: IRAs often offer a wider range of investment choices than many 401(k) plans.
• Save money on fees: If your workplace 401(k) has high fees, you may be able to save money with an IRA. However, be sure you don’t miss out on your employer’s match!
• Consolidating your accounts: Change jobs often? Rolling over multiple 401(k)s into a single IRA simplifies account management.
• Changing careers: While many employees will roll an existing 401(k) into a new one at their new employer, if your new career path doesn’t have a 401(k) available, transferring to a self-managed IRA can give you more control over those funds. 

It’s important to choose an IRA with a similar tax status or be prepared to foot the bill. For instance, if you leave your job, you can roll your previous employer’s traditional 401(k) into a traditional IRA—even if the rollover amount is above the contribution limit—and you won’t have to pay taxes. However, if you roll it into a Roth IRA, the rollover could become a taxable event..
 

Other Types of IRAs

While traditional and Roth IRAs are common for individual investors, there are other IRA variations available to suit a number of diverse needs. 

Simplified Employee Pension Plans (SEP)

A SEP IRA is a retirement plan for self-employed individuals and small business owners. SEP IRAs allow employers to make tax-deferred contributions to both their personal retirement accounts and their employees' retirement accounts.  The limits on SEP IRAs are much higher than traditional IRAs depending on the income of the business.  SEP IRAs are taxed the same way Traditional IRAs are, although. contributions can only be made by the employer and are tax-deductible for the employer only. 

Spousal IRAs

With a spousal IRA, working spouses contribute to an IRA on behalf of their non-working (or lower earning) spouse. The contribution limits are the same as regular IRAs, but spouses must file a joint tax return. Because IRAs require that you have some earned income, this can allow couples with one non-working spouse to boost retirement savings.

Inherited IRAs

An inherited or beneficiary IRA is an account that you inherit from someone else upon their passing, like a parent or spouse. If the account is a Roth IRA, withdrawals won’t be taxed. Generally inherited IRAs do not have a 10% penalty for withdrawal, even if the beneficiary is under 59½. Still, it is always best to check with your tax advisor before making a withdrawal. 

The SECURE Act requires that most beneficiaries withdraw all funds within 10 years, but if you inherit the IRA from a spouse, you may be able to roll it into your own IRA.  The rules associated with these types of accounts are vastly different than they were even 5 years ago, it is important to speak with a financial professional to determine the best route for you if you find yourself inheriting an IRA or plan to leave one to your heirs.

Open an IRA with FNBT

Retirement planning can be a complex undertaking, with considerations from income needs to tax advantages. At FNBT, we’re always here to help our clients navigate their long-term financial plans, from choosing the right retirement account to calculating a savings strategy to meet their retirement goals.

Reach out to our wealth management team today or call your local branch office in Southern Wisconsin or Northern Illinois to make an appointment. We’re eager to answer your questions and help you get on the path to a worry-free retirement!

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