Best IRAs
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IRAs: A Closer Look

Individual Retirement Accounts, also known as “Individual Retirement Arrangements” or “IRAs,” first came about in the United States in 1975, as a result of the Employee Retirement Income Security Act (ERISA), which had been enacted the year before.

An IRA is essentially a brokerage account where you can invest in an array of securities or investment products, such as stocks, bonds, exchange-traded funds (ETFs) and mutual funds, and earnings grow on a tax-free or tax-deferred basis. This allows you to not only save money, but earn it too, thanks to the power of compound interest. You can open an account  at banks, credit unions, brokerage firms, mutual fund, or even at life insurance companies.

There are two main types of IRAs: traditional and Roth. They both have the same contribution limits and share some of the same restrictions. The most significant difference between them is the way they’re taxed.

With a traditional IRA, your money grows tax-deferred so that any qualified withdrawals will be taxed as ordinary income. On the other hand, Roth IRAs are usually funded with after-tax dollars, meaning that you won’t have to pay taxes on any qualified withdrawals.

Another big difference between both types of IRAs is that, if they meet certain requirements, contributions made to a traditional IRA are tax-deductible, whereas those made to a Roth IRA aren’t.

Other popular types of IRAs include spousal, nondeductible, self-directed, SEP (Simplified Employee Pension) and SIMPLE (Savings Incentive Match Plan for Employees).  

Here’s how they compare to each other:

Benefits of Traditional IRAs

During the past few decades, the number of companies that provide a defined benefit plan for their employees has decreased, particularly in the private sector, according to the most recent data published by the Social Security Office of Retirement and Disability Policy. The same data suggests that employers seem to be leaning more towards defined contribution plans, such as 401ks, but not everyone has access to an employer-sponsored plan.

Traditional IRAs have become the go-to alternative for people who want to save money for retirement, but can’t participate in an employer-sponsored plan. However, IRAs are more than just an account to sock away money for retirement, here are some of the benefits you could obtain by opening one:

• Supplement a pension plan – if you already participate in a 401k, SEP or SIMPLE IRA (or on any other pension plan), you can still open a traditional IRA for additional retirement savings, although some contribution restrictions may apply.

• Tax advantages – this is probably the most popular benefit of opening a traditional IRA. Most contributions are tax-deductible, investments grow tax-deferred and they may lower your adjusted gross income (AGI), allowing you to qualify for some exemptions or credits.

• More investment options – when you participate in an employer-sponsored plan, your investment options are limited to what’s available in your company’s plan. If you choose to open a traditional IRA on your own, you’ll have access to a broader range of investment products (usually with lower underlying costs) and more control over asset allocation.

• Protection in case of bankruptcy –  one thing you don’t have to worry about when filing for bankruptcy is the money you invested in your IRA. Thanks to the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), funds in an IRA are protected from creditors when you file for bankruptcy, up to $1,362,800.

• Estate planning – IRAs can be a powerful estate planning tool, since you can assign a beneficiary (which can be a spouse, a non-spouse, or a trust) and leave them the funds in the account as an inheritance.

• Safety net in the event of a job loss – if you lose your job or quit your job, you can always roll your contributions over to the retirement plan (whether it's 401k, SEP, or SIMPLE IRA) and any employer contributions, as long as they’re vested, to a traditional IRA and you won’t lose those funds.

How Do Traditional IRAs Work?

Here’s how traditional IRAs work:

What can you Invest in?

One of the main perks of opening a traditional IRA is that you can invest your money in many different ways and personalize your portfolio based on how much risk you’re willing to tolerate. Some of the most common investment choices available for traditional IRAs are:

• Stocks – these are shares of a company. When you purchase a stock, you basically own a piece of that company. They are highly volatile since their returns are based on the company’s performance and other market conditions, but they offer better returns than other investment products.

• Bonds – bonds are loans made to private corporations, municipal, government and federal agencies. They pay interest income on a regular basis and are considered a low-risk securities, meaning that they offer lower returns than more volatile securities like stocks.

• Mutual funds – these are programs created by investment companies where you can purchase shares from a portfolio composed of stocks, bonds, and other securities. They are professionally managed and have higher underlying costs than other investments.

• Exchange-traded funds (ETFs) – ETFs share features of both stocks and mutual funds. When you purchase an ETF, you’re investing in a share of a diversified portfolio, but that can be traded just like stocks. Most ETFs track a particular index, such as the S&P 500.

• Options – these are contracts that allow you to buy or sell a security, like stocks or bonds, at a specified price on a specific date.

• Futures – futures are similar to options, the main difference is that with a futures contract you have the obligation to buy or sell the investment in question at the agreed price, on the date that’s stipulated in the contract.

• Certificates of Deposit (CDs) – are offered by banks and credit unions. When you invest in a CD, you make a lump sum deposit and let it accrue interest until its maturity date. They are low-risk investments and are best suited for those close to the age of retirement.

• Annuities – these are financial products designed to provide a steady income stream during retirement. Although it may seem redundant to invest in an annuity within your IRA, it could be useful for those looking to catch up on contributions, as they earn income regularly at a fixed or variable rate.

• Real estate – as part of your IRA portfolio, you can invest in shares of office buildings, industrial complexes and other real estate, so long as you don’t own it.

Requirements and Restrictions

Traditional IRAs are one of the most inclusive retirement plans available. Almost anyone can contribute to them and there are no income limitations. Still, the IRS requires consumers to be under the age of 70 ½ and have taxable compensation, in order to open this type of account.

The IRS defines taxable compensation as any wages, salaries, commissions, self-employed income, nontaxable combat pay, alimony, and separate maintenance earned during the fiscal year. In other words, if your income comes from investments, earnings and profits from property, pension or annuity payments, you won’t be able to open a traditional IRA.

Besides the age and income source requirements mentioned above, the IRS also establishes certain restrictions when it comes to the investments that can be held within an IRA.

Some of the things you can’t invest in are life insurance, artwork, rugs, antiques, gems, stamps and metals (except for certain kinds of bullion). Any money invested towards any of these items, will be considered an early distribution by the IRS and you could face a 10% tax penalty on those contributions.

Penalties and Exceptions

The contributions and earnings from an IRA are supposed to remain untouched until you reach the age of 59 ½. At that point, any money you take out is considered by the IRS as a qualified withdrawal or distribution and is taxed as ordinary income.

Although you may withdraw funds from your IRA whenever you want, doing so before reaching the age of 59 ½ comes with its consequences. In addition to paying ordinary income tax on any withdrawals, the IRS may charge you a 10% tax penalty for taking an early distribution.

However, there are some exceptions. The IRS will waive the 10% tax penalty if used for any of the following reasons:

• Paying for unreimbursed medical expenses that exceed 10% or your AGI

• Health insurance premium payments while unemployed

• To cover costs during temporary or permanent disability

• To fund higher education expenses

• Pay an IRS levy

• Rolling over to another retirement plan within 60 days

• First home purchase (up to $10,000 per individual or $20,000 for couples)

• Military withdrawals during active duty

• Withdrawals from an inherited IRA

It should be noted that you don’t have to touch the funds in your IRA once you hit 59 ½. You can let the money grow tax-deferred until you’re 70 ½. Once you reach that age, you must withdraw a specific amount each year. This amount is known as a “required minimum distribution” and it is calculated on a case-by-case basis, using factors such as your account balance and estimated rate of return. If you fail to make any withdrawals or withdraw less than the amount required, you could face a 50% excise tax on the undistributed amount. 

Maximum Contributions and Deductions

As of 2019, the maximum contribution allowed for traditional IRAs is of $6,000 or $7,000 if you’re 50 or older, since you’re allowed to make an extra $1,000 catch-up contribution just for being closer to the age of retirement. For the most part, these contributions are tax-deductible, but the amount can vary depending on your filing status and whether you participate in an employer-sponsored plan.

Here’s a quick breakdown on how much you can deduct if you already participate in an employer pension plan:

As we mentioned above, IRAs can be opened through banks, credit unions, brokerage firms, life insurance and mutual fund companies, but in the end, these institutions really just act as custodians for the account. The IRS is the government agency that oversees retirement and pension plans, so all custodians must abide by the rules and guidelines established by the agency in order to offer these types of plans.

Besides being regulated by the IRS, investments made through IRAs are insured by either the Federal Deposit Insurance Corporation (FDIC) or by the Securities Investor Protection Corporation (SIPC). If your IRA invests in fixed rate products, like certificates of deposits, or in other safe banking products, like a savings account, your assets are protected by the FDIC up to $250,000. If your IRA invests in securities, such as stocks, bonds or ETFs, then investments are protected by the SIPC up to $500,000, with a $250,000 cash limit.

Regardless, it’s important to remember that IRAs are an investment account and, as such, you’re always at risk of losing money, depending on market conditions. While the FDIC or SIPC may both cover you in case of fraud or if your custodian goes under, they don’t offer protection against loss due to asset depreciation.

Expert Tips

Besides researching and comparing what the different financial institutions have to offer when it comes to IRAs, here are a few pieces of advice from our experts:

How do Traditional IRAs Compare to Other Retirement Plans?

Now that we’ve discussed the ins and outs of traditional IRAs, it’s time to see how they compare to other retirement plans: