How Does an IRA Work? A Guide to Tax-Advantaged Retirement Savings

Planning for retirement is essential, and an Individual Retirement Account (IRA) is one way to save for the future. IRAs offer tax advantages that can help grow your retirement savings over time, making them a valuable tool for long-term financial security.

Understanding how IRAs work, the different types available, and the 2025 contribution limits will help you make informed decisions about your retirement savings.

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Types of IRAs

There are several types of retirement accounts, each with unique tax advantages and rules:

• Traditional IRA – Allows tax-deferred growth, meaning contributions may be tax-deductible, and taxes are paid when withdrawing funds in retirement.
• Roth IRA – Contributions are made with after-tax dollars, and qualified withdrawals—including earnings—are tax-free in retirement.
• SEP IRA – Designed for self-employed individuals and small business owners, allowing employer contributions with higher limits.
• SIMPLE IRA – A retirement plan for small businesses that enables both employer and employee contributions, serving as an alternative to traditional 401(k) plans.
• Solo 401(k) – A retirement plan for self-employed individuals and business owners with no full-time employees, providing high contribution limits and both Traditional and Roth options.

It's important to note that Self-Directed IRAs (SDIRAs) are not a separate type of account. Traditional, Roth, SEP, Solo 401k’s, and SIMPLE IRAs can all be self-directed, meaning investors can choose from a broader range of assets, including but not limited to real estate, private equity, promissory notes, and cryptocurrency.

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2025 IRA Contribution Limits

For 2025, the IRS has set the following contribution limits:

• Traditional & Roth IRAs: The contribution limit remains $7,000 per tax year, with an additional $1,000 catch-up contribution for individuals aged 50 and older, bringing their total to $8,000.
• SEP IRAs: Employers can contribute up to 25% of an employee’s compensation, with a maximum contribution of $70,000.
• SIMPLE IRAs: Employee salary deferrals are capped at $16,500, with an additional $3,500 catch-up contribution for those 50 and older, bringing their total to $20,000. Those between 60-63 have an additional catch-up contribution, bringing their total to $21,750
• Solo 401(k): The combined employer and employee contribution limit is $70,000, with a catch-up contribution of $7,500 for those 50 and older, allowing a total of $77,500. Those between 60-63 have an additional catch-up contribution, bringing their employee contribution to $34,750 and their total contribution to $81,250

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Diverse Options

Once money is contributed to an IRA, it can be diversified into a variety of assets depending on the account type and who your administrator or custodian is:

• Traditional Investments: Stocks, bonds, mutual funds, and ETFs, commonly available in standard IRA accounts.
• Alternative Investments: Real estate, private equity, promissory notes, cryptocurrency, and other non-traditional assets, which are available through Self-Directed IRAs.

Self-directed IRAs allow for diversifying above and beyond stocks and publicly traded assets, but they also require a third-party administrator or custodian and careful adherence to IRS rules to avoid prohibited transactions.

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Withdrawal Rules and Tax Implications

The rules regarding withdrawals differ based on the type of IRA:

• Traditional & SEP IRAs: Withdrawals after age 59½ are taxed as ordinary income. Early withdrawals may incur a 10% penalty plus income taxes unless an exemption applies.
• Roth IRAs: Contributions can be withdrawn at any time without penalties or taxes. Earnings can also be withdrawn tax-free after age 59½, provided the account has been open for at least five years.
• SIMPLE IRA & Solo 401(k): Similar to Traditional IRAs, these accounts impose taxes on withdrawals, with potential penalties for early distributions.
• Required Minimum Distributions (RMDs): Traditional, SEP, SIMPLE IRAs, and Solo 401(k)s require withdrawals starting at age 73. Roth IRAs do not have RMDs during the account holder's lifetime.

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Tax Considerations

Each type of IRA offers different tax considerations:

• Traditional IRA, SEP IRA, SIMPLE IRA & Solo 401(k): Contributions may be tax-deductible, and investments grow tax-deferred, meaning taxes are paid when funds are withdrawn.
• Roth IRA & Roth Solo 401(k): Contributions are made with after-tax dollars, and both investment growth and qualified withdrawals remain entirely tax-free, provided you are over 59 ½, and your Roth account has been open for at least five years.

Choosing the right IRA depends on your tax situation, retirement goals, and whether you want tax advantages now (Traditional IRA) or in retirement (Roth IRA).

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Final Thoughts: Which IRA is Right for You?

IRAs provide a solid foundation for retirement savings, but selecting the right one depends on your financial goals. If you want flexibility to invest in alternative assets, a Self-Directed pre-tax IRA may be a good option. A Roth IRA could work if tax-free retirement income is a priority. For self-employed individuals looking to maximize contributions, a Solo 401(k) or SEP IRA are common options.

Since tax laws and contribution limits change periodically, consulting with a financial planner or CPA is always recommended. A professional can help you navigate contribution limits, tax implications, and investment strategies to ensure you make the best retirement savings decisions for your own situation.

Do you have questions, or would you like to explore a specific type of IRA in more detail? Feel free to contact us anytime!