Chapter 3 — Individual Retirement Accounts

Since their inception, Individual Retirement Accounts (IRAs) have evolved into a number of variations. IRAs may be set up by individuals on their own behalf, or established by employers for the benefit of employees. Almost anyone who earns income may open an IRA.

There are two general types of IRAs that may be established by individuals: traditional IRAs (in which contributions may or may not be tax-deductible) and Roth IRAs (in which contributions are never deductible but qualified distributions are tax-free). Regardless of the type established, total contributions by an individual to all of their IRAs combined may not exceed the annual contribution limit.

Employers, too, have a variety of IRA alternatives. Employers may contribute to an employee’s existing IRA or establish more formal IRA programs such as Simplified Employee Pensions (SEPs) and Savings Incentive Match Plans for Employees (SIMPLE plans) — discussed in Chapters 4 and 7. In employer-sponsored IRA arrangements, the maximum contribution on behalf of an employee may far exceed the annual individual IRA limit, and these contributions are generally tax-deductible for the employer.

These limits apply to the combined total of all traditional and Roth IRA contributions made by the individual for the year. Contributions may not exceed the individual’s taxable compensation for the year.

Traditional IRAs allow individuals to contribute annually to an account that is invested and grows tax-deferred. Tax-deferred growth is one of the prime advantages — the account compounds without current income tax on dividends, interest, or capital gains. Upon retirement, the individual may withdraw funds from the IRA. Distributions are taxable as ordinary income in the year received. The IRS also imposes a 10% penalty on most withdrawals prior to age 59½ and requires withdrawals to begin no later than age 73 (age 75 for those born after 1959, starting in 2033).

In some cases, contributions to a traditional IRA are tax-deductible, effectively allowing before-tax dollars to be contributed. Deductible IRAs offer two tax benefits: an immediate reduction in the contributor’s tax bill and tax-deferred growth inside the account. Whether a contribution qualifies for a deduction depends on two factors:

• whether the contributor (or spouse) is covered by a workplace retirement plan, and
• the contributor’s modified adjusted gross income (MAGI).

If neither the contributor nor their spouse is covered by any employer plan, all contributions are fully deductible regardless of income.

For contributors covered by a workplace plan, the 2026 deduction phase-out ranges are:

Below the phase-out range, the full contribution is deductible. Above it, contributions are not deductible. Within the range, a partial deduction is available. Because all contributions and earnings were sheltered from tax, any withdrawals from a fully deductible IRA are fully taxable as ordinary income.

Individuals who are not eligible for a deduction may still contribute to a traditional IRA. While the immediate tax benefit is absent, the account still provides tax-deferred growth. Essentially, after-tax dollars are placed into a tax-deferred account.

Distributions from nondeductible IRAs represent a mix of return of basis (already taxed contributions) and earnings (not yet taxed). Only the earnings portion of each withdrawal is subject to income tax. The exclusion ratio determines what portion of each distribution is tax-free. Contributors must file Form 8606 each year to track their nondeductible IRA basis.

Roth IRAs are fundamentally different from traditional IRAs. Contributions to a Roth IRA are never tax-deductible — they are always made with after-tax dollars. However, the account grows tax-deferred and all qualified distributions are completely tax-free. Because the tax benefit comes at the back end rather than the front end, Roth IRAs are sometimes called “backloaded” IRAs.

Roth IRAs also offer significant flexibility advantages over traditional IRAs: many early withdrawal penalties do not apply to the return of contributions (though earnings remain restricted), and there are no required minimum distributions during the owner’s lifetime.

Above the phase-out ceiling, no Roth IRA contribution is permitted. Unlike the traditional IRA deduction phase-out, which is based on workplace plan coverage, the Roth income limit applies regardless of whether the contributor participates in any other plan.