What is an IRA and How Does it Work? [IRA for Dummies]

Quick facts:

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• IRAs have annual contribution limits and come in two types
• Roth IRAs invest after-tax dollars now to avoid taxation on gains later (at retirement) and have income-eligibility requirements
• Traditional IRAs invest before-tax dollars now and defer taxes until withdrawal (at retirement) and can be used by anyone with sufficient earned income during the tax year

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If you’re like my wife and me, you like to plan for the future. But however cautious we are, plenty still gets in the way. Like paying rent. And utilities. And groceries. And, well, everything else. Life has plenty to offer but it also has plenty to pay for. So far, though, no real regrets. We both have great jobs (or will) and make enough to be comfortable, but we also recognize some big purchases lay ahead.  And even more, the time to start repaying her student loans comes increasingly near.

In the meantime, we’ve been piling as much as possible in our retirement accounts in anticipation of these events.  We do this because we know it will be difficult to continue at this clip without making some sacrifices.

For the past five years, we’ve maxed out contributions to our Roth individual retirement accounts (IRAs) and come close to hitting the $22,500 annual limit (2023) available to me through my employer-sponsored 401(k) retirement plan ($23,000 in 2024).

In 2019 through 2024, I finally managed to hit the 401(k) maximum while I have reached my IRA limit each year since finishing graduate school 10 years ago. As a result, I have a little bit more saved, but not terribly much. By throwing as much in those accounts as possible, we let tax-advantaged, compounding returns work their magic. We select low-cost investments suitable to people our age and let them ride.

Don’t get me wrong, we check them regularly to make sure everything is on track, but we know there will be ups and downs. In the end, we know it’s the time spent in good, tax-advantaged investments that saves us the stress of preparing for retirement.

With that in mind, let’s turn to discussing the benefits of using IRAs so you too can take advantage for your retirement.

What is an IRA?

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An individual retirement account (IRA) is what helps you save for retirement! There are many types of IRAs, but what they all have in common is that they help individuals accumulate money in a tax smart manner to spend later in life during retirement.

These accounts offer tax breaks or deductions on your income taxes and let you invest your money with a financial institution such as a bank or an investment firm. Each year, you can contribute up to the lesser of the annual limit or your earned income.

IRAs come in two primary types:

• Traditional IRAs
• Roth IRAs

A traditional IRA is what most people think of when they hear “IRA.” This type allows you to deduct your contributions from taxable income in the year of contribution, but any growth or interest earned within will be taxed when you make withdrawals in retirement.

A Roth IRA allows you to pay taxes upfront and see your money grow tax-free. You will not be taxed on your withdrawals in retirement.

How Does an IRA Work?

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An IRA works by allowing you to invest your money in stocks, bonds and other assets. You will then be able to withdraw this money later in life when you retire or need it for some other expense that has come up. Additionally, the IRS offers what is called a “catch-up provision” if you are over 50 years old where each year you can contribute an extra $1,000 to your IRA.

When you earn income, you can contribute toward your retirement through an IRA. If you open a traditional IRA, you’ll need to mind a few details later on related to required minimum distributions (RMDs). Because you never paid taxes on your contributions upfront and the IRS wants tax revenue, if you haven’t already begun to take money from your account by age 73 (if you turn 72 after December 31, 2022, otherwise your RMDs start at age 72), you must comply with RMDs.

These represent money you must take from your account, whether you need it at that time or not. Roth IRAs do not face RMDs because you already paid tax on your contributions upfront.

Related: IRA Contribution Limits: Save More For Retirement

Tax-Advantaged Investment Accounts

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The federal government understands the importance of saving for retirement. They do this by having the tax code allow individuals to fund tax-advantaged investment vehicles for holding retirement investments.

Primarily, there are two categories of retirement accounts available to individuals in the United States: a self-directed IRA or an employer-sponsored retirement plan in the form of a 401(k) or 403(b).

This post focuses on the former and explores the key advantages of using this account to prepare for retirement as well as the differences between a Traditional and Roth IRA.

Related: The Best Retirement Plans [Workplace + Individual]

What are the Benefits of an IRA?

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Unlike employer-sponsored plans, which typically have limitations on investment options and assess higher fees, IRAs offer much greater flexibility at a potentially lower cost. This broader range of options helps individuals have a chance to diversify their investment portfolios by investing in more than the usual fare included in most employer-sponsored plans (i.e., mutual funds or target date retirement products).

This includes investing in index funds, individual equities, real estate-linked investment products, alternative investment options, consumer debt, peer-to-peer lending, etc. We’ve made IRA contributions to accounts at Vanguard and Betterment and we invest in multiple different asset classes to add diversity to our portfolio.

Some options are more expensive than others. We think the best stock trading apps offer a lot for a little. We tend to steer away from the pricier ones unless we feel comfortable that those investments can offer diversification benefits. Index funds like VTI or VTSAX, even VFIAX make great low-cost, diversified investments.

But, as you can see, there are plenty of IRA options available to you.

What are IRA Contribution Limits?

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IRAs have annual contribution limits that require you to earn income in order to contribute. For 2023 and 2024, the maximum contribution an individual can make is the lesser of $7,000 ($8,000 if age 50 or older) OR your earned income.

Said differently, if you earned $2,500 in 2024, your maximum contribution this year is $2,500. If you earned income in excess of $7,000, then you can contribute up to the maximum.

These retirement plan contribution limits don’t compare favorably with employer-sponsored plans, which can go up to $23,500 ($30,500 for age 50+) in 2024.

However, these employer-sponsored plans typically don’t offer as many options and not all companies offer their employees a defined contribution (401(k) or 403(b)) or defined benefit (pension) retirement plan.

If the employer-sponsored plan is available to you, using both of these accounts can help to meet your retirement goals.

Related: How to Max Your 401(k) + Other Retirement Accounts

Individual Retirement Account Income Eligibility Requirements

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Next year, because my wife’s job will increase our combined income, we may only have Traditional IRAs and my 401(k) plan to contribute toward our retirement savings. Remember, anyone with sufficient earned income may contribute to a Traditional IRA, the question just becomes whether you can deduct those contributions above certain income levels.

But if you aren’t above that threshold, is the Roth IRA right for you? How do you know which type of IRA is better for your situation? Which should you choose?

To figure that out, first, you’ll need to earn a sufficient level of income to contribute to an IRA. From there, your modified adjusted gross income (MAGI) will be the determining factor.

MAGI is different from your taxable income and can be calculated using this handy IRS worksheet.

For the 2024 tax year, the maximum amount you can contribute to a Roth IRA is gradually reduced to zero if your 2024 MAGI is:

• $146,000 to $161,000 for single and head-of-household filers ($138,000 to $153,000 for 2023)
• $230,000 to $240,000 for joint filers ($218,000 to $228,000 for 2023)

That also means you can’t contribute to a Roth IRA at all for 2024 if your modified AGI for the year is:

• $161,001 or more if you use the single or head of household filing status on your tax return ($153,001 for 2023)
• $240,001 or more if you’re married and file a joint return ($228,001 for 2023)

Tax Benefits of an Individual Retirement Account

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After determining eligibility, you’ll need to evaluate which IRA type is best for your personal tax situation. The key question to ask yourself is whether you expect to be in a higher tax bracket at retirement than you are now. Also keep in mind the 2018 tax reform changes might have lowered limits through 2025, but they are not permanent as of now.

Tip the Taxman Now or Later

If you contribute to a Roth IRA, you pay taxes now and not when you withdraw funds at retirement. If you suspect tax rates will increase or you will retire in a higher tax bracket, then the Roth IRA will protect you.

Conversely, with a Traditional IRA, you save money now by paying taxes later. The strategy is the opposite for the Traditional IRA: if you think your tax rates will be lower later, you should contribute to the Traditional IRA.

Tax-Free Growth

Some other key benefits to a Roth IRA include the ability to watch your money grow tax free for longer. Traditional IRAs require you to take required minimum distributions (RMDs) every year once you reach age 72 (or age 73, if you turn 72 after December 31, 2022), regardless of your need for the money. The government never received tax revenue from those funds when you contributed them and wants to get what it’s due at some point. RMDs accomplish this goal.

With a Roth IRA, you paid your taxes upfront and you can ignore these RMDs. Your money can stay in the account and continue growing tax-free.

Tax-Free Inheritance

An additional benefit is leaving a tax-free inheritance to your heirs. What do I mean by that? The people who stand to inherit your Roth IRA when you land that great gig in the sky won’t have to pay any federal income tax on withdrawals so long as the account has been open for at least 5 years.

While you might not get to enjoy this benefit, your heirs will certainly appreciate it. All of these benefits sure make the Roth IRA look like a great choice. But what if you make too much to qualify and you still really want to put your money in a Roth IRA?

There’s still an option, should you choose to take the “back door.”

Taking the IRA “Back Door”

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At first blush, it might sound disappointing if you find yourself ineligible for contributing to a Roth IRA because of your high income. However, there’s good news for you.

Tax rules allow you to get around this restriction by converting funds you hold in a Traditional IRA or 401(k)/403(b) to a Roth IRA. There aren’t income limits for this conversion nor on how much you can convert.  Your only restriction is being able to rollover funds once a year.

That’s great news, right? It could be. Keep in mind, however, that downsides exist to this strategy:

• In most instances, this conversion creates what the IRS calls a “taxable event” and you may owe taxes on some or all of the amount converted
• Unlike Roth IRA contributions, which can be taken out of the account at any point without consequence, converted Roth IRA funds must stay in the account for at least 5 years or you will incur penalties for withdrawals
• Roth conversions completed after 12/31/17 cannot be reverted back to a traditional IRA later

One strategy for mitigating the item is to take advantage of upcoming life or career changes which might have you earning lower income temporarily.

For example, my wife and I plan to convert her Traditional 401(k) account from her intern year between medical school and her residency before our income jumps next year.

That way, we pay less taxes on the conversion this year while we are in a lower income tax bracket.

As a note of caution, before doing this you should consider your specific situation and consult a tax professional should you choose to follow this path. This post does not in any way qualify as tax advice.

So, to recap, a “backdoor” conversion can get you into a Roth IRA, even if your income is too high. The process involves 2 steps:

1. Place your contribution into a Traditional IRA (remember, no income limits), and
2. move the money into a Roth IRA using a Roth conversion.

But be aware of tax consequences for this strategy because doing this creates a “taxable event” which will create added tax liability in the year of conversion.

One other wrinkle is that the money you convert cannot be accessed without penalty for five years after conversion because those aren’t considered “contributions” in the IRS’s eyes.

Regular Roth IRA contributions can be taken out as needed after being contributed without penalty.

Carpe Diem – Contribute What You Can Afford (Or More) to Your IRA

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My wife and I regularly discuss what we want out of life and how to go about getting it. Also important in this planning is identifying how to finance our aims.

While fortunate to find each other for many reasons, our bedrock is a shared set of life and financial goals. Common among our objectives are raising a family, finding an affordable home for our needs, working in rewarding jobs, and retiring comfortably at a reasonable age. After all, we want retirement to work in our favor.

We regularly examine our financial picture to make sure our goals are achievable and we look to overcome any obstacles in our way. By using our Roth IRAs to pay lower taxes now we will have our retirement investments grow tax-free. If we can avoid withdrawing funds from our Roth IRAs, we make these goals all the more achievable. However, if we need to, we certainly have the option. And sometimes, it’s nice to have the option, even if you don’t end up using it.

If you have interest in opening an individual retirement account, consider Vanguard for selecting individual stocks, index funds, or other securities. This is one of the best stock trading apps for beginners and can easily be used for investing over the long-term.