How IRAs work: An overview

Certain money topics raise questions, no matter how often they’re written about. For example, consider the individual retirement account, or IRA. IRAs have been a popular tax-advantaged way to diversify investments for retirement since their introduction in the 1970s.

But all the options and information out there can leave you wondering if an IRA is right for you. Get your questions answered here, and you’ll be on your way to a better understanding of the two common types of IRAs—traditional and Roth.

IRA stands for individual retirement account. It may help to think of it as a folder that holds your investments for retirement.

Inside your IRA, you may have stocks, bonds, mutual funds, certificates of deposit (CDs), money market funds and other investments you choose depending on your goals, risk tolerance and time until you plan to retire. IRAs have the potential to grow and offer tax advantages.

The main differences between a traditional IRA and a Roth IRA are how each is taxed and how you make withdrawals.

A traditional IRA is typically funded with pre-tax dollars, and any taxes you will pay are deferred until you begin withdrawals.

With a traditional IRA, your contributions are tax-deductible if you and your spouse don’t participate in an employer-sponsored plan. If either of you does participate in an employer plan, your contribution would be tax-deductible as long as your income is below certain income thresholds.¹

With a traditional IRA, you must begin making required minimum withdrawals by the time you reach age your required beginning date (RBD). Your RBD depends on the year you were born:

Born in 1950 or earlier: RMD start age is 72.
Born between 1951-1959: RMD start age is 73.
Born in 1960 or later: RMD start age is 75.

Since you get a tax benefit up front, you’ll pay tax on the money you withdraw in retirement. But at that stage of life, you might be in a lower tax bracket than you are now—which is a potential benefit.

With a Roth IRA, each dollar you contribute is one that you’ve paid tax on already.

Roth IRAs do not have a minimum age for withdrawals (see “How long can I leave the money in my IRA?” below). Also, you may take withdrawals of the Roth IRA contributions you have made without taxes or penalties, but early withdrawals of earnings may be subject to taxes and penalties.

You may contribute to a Roth IRA if your modified adjusted gross income for 2022 is less than $129,000 (single filer) or less than $204,000 (joint filer).³ These numbers increase for 2023 to less than $138,000 (single filer) or less than $218,000 (joint filer).⁴ If your income is between $218,000 and $228,000 there is a phase out contribution limit. Income limits do not apply if you are completing a Roth IRA conversion.³

When you withdraw money from a Roth IRA, if it’s a qualified distribution², all of it comes out tax-free—both the dollars you contributed and your earnings on those dollars.

You must have earned income to contribute to either type of IRA, and contribute no more than the lesser of 100% of your earned income or the following amount for all traditional and Roth IRAs you own:

• If you are younger than age 50, you can contribute up to $6,500 in 2023 for Roth and traditional IRAs.
• If you are age 50 or older, the annual catch-up provision allows you to contribute up to $7,500 in 2023.

Yes. As long as you have earned income, you can have both types of IRAs but the annual contribution limit will apply. You may split your annual contribution among your IRAs, up to the maximum for that year. If you contribute the maximum to your Roth IRA, for example, you cannot add to your traditional IRA that year.

The deadline to make contributions to your IRA is the same as the tax return deadline. For example, you can contribute to your traditional IRA or Roth IRA for 2022 until April 17, 2023. Tax Day is usually April 15 but can vary if that’s not a business day.

The extended contribution deadline is one unique aspect of the IRA versus other tax deductions you may qualify to use, which must be taken on or before Dec. 31 each year.

You may access your IRA funds but taking money that has been earmarked for retirement out of accounts early should be a last resort due to the potential for lost earnings and penalties you may pay.

That said, if you take money from your IRA before you retire, there may be early withdrawal penalties, depending on your age and how the money will be used. Generally, early withdrawals from your IRA before age 59½ would be included in your income for the year for tax purposes, plus an additional 10% tax penalty. See IRA differences above for information on Roth IRA withdrawals.

There are exceptions with the 10% penalty, including to pay health insurance premiums after a job loss, to purchase a first home, to help pay for the birth or adoption of a child, and to help pay qualified education costs for you or a family member.

Divorce is another major life event during which potential taxes and penalties may not be imposed. IRAs and other retirement assets would be split according to the divorce settlement agreed to by both former spouses and may retain tax-deferred status.

You can review the full list of exemptions for early withdrawals here.

If you have access to an employer-sponsored retirement plan, such as a 401(k), 403(b) or similar account, you should consider taking advantage of that saving opportunity. This is especially true if your employer offers to match a portion of the amount you contribute each year.

If you’ve contributed to your employer-sponsored retirement plan at work up to the match offered by your employer, consider investing additional dollars beyond your employer match into an IRA.

Another reason to consider a traditional IRA or Roth IRA is that you may have access to a wider range of investments than what is offered in an employer-sponsored plan.

Read: How to know you’re saving enough for retirement.

With a traditional IRA, you may begin taking money from your account without penalty at age 59½. And you must begin making required minimum distributions (RMD) by your required beginning date (RBD).

The Roth IRA offers more flexibility with withdrawals than traditional IRAs. If you are taking out your contributions from your Roth, no penalty will apply. And no penalty applies to potential earnings if you meet one of these penalty exceptions. Furthermore, you never need to begin RMDs with a Roth IRA. Distribution rules will apply to beneficiaries.

Any assets that remain in your IRA when you die will go to the beneficiaries you have designated. It’s important to review and update beneficiary designations whenever you experience life events such as marriage, divorce, births and deaths. The current beneficiary designation will override your will if you have one (see essential estate planning documents.)

• Or your spouse is currently earning income.
• Think you’ll be in the same or a lower tax bracket in retirement.
• Would benefit from a potential immediate federal income tax deduction.¹
• Do not think you will need to take money out of the account until retirement (taxes and penalties will apply unless you meet an IRA penalty exception).

• Or your spouse is currently earning income, and your modified adjusted gross income for 2023 is less than $138,000 (single filer) or less than $228,000 (joint filer).
• Think you’ll be in a higher tax bracket in retirement.
• Would benefit from federal tax-free qualified distributions in the future.
• Want to flexibility to take out the money you’ve contributed before age 59½ without penalties.²
• Want the option to let your money grow as long as you’d like without required minimum distributions at a certain age.
• Would like to leave it to a beneficiary tax free (given you’ve had the account for at least five years).
  

  

No matter what type of IRA you choose, you’re putting tax-deferred compounding to work for your retirement assets. There are many ways to work tax efficiency into your financial strategy. While Thrivent does not provide specific legal or tax advice, we can partner with you and your tax professional or attorney to help deliver optimal tax outcomes with your goals. A financial advisor can help you determine if an IRA is right for you.