What Are IRA Accounts and How Do They Work?

Individual Retirement Accounts (IRAs) are a vital aspect of retirement planning in the United States, offering tax-advantaged savings opportunities. Understanding their mechanics is essential for maximizing benefits and securing financial stability in retirement.

This article examines eligibility criteria, different types of IRAs, contribution rules, rollover guidelines, distribution deadlines, inherited IRA requirements, and penalties for noncompliance.

Basic Eligibility Criteria

Eligibility for IRAs hinges on having earned income, such as wages, salaries, tips, or self-employment earnings. Both Traditional and Roth IRAs require contributors to have earned income. The SECURE Act of 2019 removed the age limit for Traditional IRA contributions, allowing individuals over 70½ to contribute if they are still earning income.

Income limits are particularly relevant for Roth IRAs. In 2024, single filers with a modified adjusted gross income (MAGI) up to $153,000 can make full contributions, while those earning between $153,000 and $168,000 are eligible for partial contributions. For married couples filing jointly, the phase-out range is $228,000 to $243,000. These thresholds adjust annually for inflation.

Types of IRAs

IRAs come in several forms, each with distinct benefits tailored to various financial situations and retirement goals.

Traditional

Traditional IRAs provide immediate tax advantages, as contributions may be tax-deductible depending on income and participation in an employer-sponsored retirement plan. For 2024, the contribution limit is $6,500, with an additional $1,000 catch-up contribution for individuals aged 50 and older. Earnings grow tax-deferred, and withdrawals are taxed during retirement, potentially at a lower rate. Early withdrawals before age 59½ generally incur a 10% penalty.

Roth

Roth IRAs emphasize tax-free growth and withdrawals. Contributions, made with after-tax dollars, are not tax-deductible, but qualified distributions, including earnings, are tax-free if the account has been open for at least five years and the account holder is 59½ or older. Contribution limits in 2024 are the same as Traditional IRAs. Roth IRAs suit those anticipating higher tax brackets in retirement and offer flexibility, as they are not subject to required minimum distributions (RMDs) during the account holder’s lifetime.

SEP

Simplified Employee Pension (SEP) IRAs cater to self-employed individuals and small business owners. Employers make tax-deductible contributions, up to the lesser of 25% of the employee’s compensation or $66,000 in 2024. SEP IRAs are simple and cost-effective, appealing to small businesses with minimal administrative requirements.

SIMPLE

Savings Incentive Match Plan for Employees (SIMPLE) IRAs are designed for small businesses with 100 or fewer employees. Employees can contribute up to $15,500 in 2024, with an additional $3,500 catch-up contribution for those aged 50 and older. Employers must match up to 3% of employee compensation or provide a 2% non-elective contribution. Withdrawals within the first two years may face a 25% penalty.

Contribution Rules

For 2024, Traditional and Roth IRA contribution limits are $6,500, with an extra $1,000 allowed for those aged 50 and older. Contributions must be in cash and made by the tax filing deadline, typically April 15 of the following year.

SEP and SIMPLE IRAs have different rules. SEP IRAs allow employer contributions up to the lesser of 25% of compensation or $66,000 in 2024. SIMPLE IRAs permit employee contributions up to $15,500, with additional employer contributions required.

Rollover Guidelines

Rollovers enable transferring funds between retirement accounts without immediate tax consequences. The IRS allows rollovers between IRAs or from employer-sponsored plans like 401(k)s to IRAs. A 60-day window exists to complete rollovers to avoid taxes and penalties, though direct rollovers between financial institutions are preferred to minimize errors.

Distribution Deadlines

Distribution rules for IRAs determine when withdrawals must begin and the tax implications. Traditional IRAs are subject to RMDs, with the SECURE Act 2.0 raising the RMD age to 73 for those turning 72 after December 31, 2022, and increasing it to 75 starting in 2033. The RMD amount is based on the account balance and a life expectancy factor. Missing the RMD deadline triggers penalties.

Roth IRAs are exempt from RMDs during the account holder’s lifetime, offering flexibility. However, inherited Roth IRAs are subject to distribution requirements.

Inherited IRA Requirements

The SECURE Act of 2019 introduced a 10-year rule for most non-spouse beneficiaries, requiring the account balance to be distributed within 10 years of the original account holder’s death. Spousal beneficiaries can treat the IRA as their own or remain as a beneficiary. Non-designated beneficiaries, such as estates or charities, must follow specific distribution rules.

Penalties for Noncompliance

Violating IRA rules can result in severe penalties. Failure to withdraw the full RMD incurs a penalty of 25% of the shortfall, reduced to 10% if corrected promptly. Early withdrawals before age 59½ face a 10% penalty unless exceptions apply. Improper rollovers also lead to penalties if funds are not redeposited within the 60-day window.