Individual retirement arrangements (IRAs) are a popular way to save for retirement, and with good reason—they come with numerous benefits for investors building long-term wealth. They also come with a few drawbacks you should be aware of. In this post, we’ll break down what you need to know, focusing on two popular account types: traditional IRAs and Roth IRAs. 

IRA benefits

IRAs are tax-advantaged

Perhaps IRAs’ best known benefit is their tax-advantaged status—this benefit is designed to  encourage you to put money away for later. The tax advantages of traditional IRAs and Roth IRAs are slightly different. 

Traditional IRAs let you take a tax deduction in the year you contribute as long as you (and your spouse, if you have one) don’t have a retirement plan like a 401(k) plan at work. If you or your spouse do have a 401(k) plan at work, you can still deduct at least some of your contribution as long as you earn under $87,000 as a single filer or $143,000 as a married couple filing jointly for 2024. If your income is above the IRS limits and you’re covered by a retirement plan at work, you can’t deduct any part of your contributions (but you can, of course, still contribute). Regardless of whether or not your contributions were tax-deductible, when you take qualified distributions in retirement, those distributions are taxed like regular income. 

With Roth IRAs, you don’t get a tax break in the year you contribute, but any growth and distributions in retirement that meet the IRS’s rules (also called “qualified distributions’) will be tax-free. However, not everyone is eligible to contribute directly to a Roth IRA. In 2024, you can’t contribute to a Roth IRA directly if you earn $161,000 or more as a single filer or $240,000 or more as a married couple filing jointly. There’s a way around this. You can complete what’s known as a “backdoor Roth,” where you make a non-deductible contribution to a traditional IRA for the purpose of converting it to a Roth IRA. Wealthfront automates this process so it takes just a few clicks. Once you’ve completed the conversion, you get the same tax benefits you’d get if you contributed to a Roth IRA directly. 

IRAs have more investment options than 401(k) plans

If you have a 401(k), you’ve probably already noticed that it doesn’t give you many choices when it comes to how your money gets invested. Fortunately, this isn’t the case for IRAs. Usually IRAs, much like taxable investment accounts, come with many investment options. At Wealthfront, you can customize your IRA with hundreds of investments or invest in a pre-made Classic or Socially Responsible portfolio. 

IRAs are more flexible and liquid than you might think

Roth IRAs in particular come with a surprising amount of flexibility. If you make direct contributions to a Roth IRA, you can typically withdraw these contributions early, which means before age 59 ½, without paying additional taxes or a penalty (which isn’t the case for a 401(k) or traditional IRA). However, you’ll still owe income tax and a 10% penalty on earnings (or money you earn on your contributions) you take out of your Roth IRA before retirement with a few exceptions. For example, one popular exception allows you to withdraw up to $10,000 in earnings for a first-time home purchase. 

If you have a traditional IRA, you might be able to execute a Roth conversion and benefit from the flexibility that comes with a Roth IRA. If you decide to do this, Wealthfront offers easy Roth conversions that eliminate the paperwork and hassle. Just keep in mind that you need to wait at least five years after the Roth conversion to be able to withdraw contributions without paying a penalty.

IRAs can often have lower fees than 401(k) plans

At Wealthfront, we think it’s important to minimize fees. When you invest, you’ll typically pay for what’s known as the expense ratio (the fee charged by an ETF’s issuers to manage the fund) as well as advisory fees. It’s important to keep an eye on the fees you’re paying, because over time they eat into your returns.

Average 401(k) advisory fees are generally between 0.5% and 2%. IRAs, on the other hand, are typically less expensive. Wealthfront’s IRAs are subject to our low 0.25% annual advisory fee.

IRA drawbacks

IRAs have low annual contribution limits

One drawback of using IRAs to save for retirement is that the annual contribution limits are relatively low. In 2024, you can contribute up to $23,000 to a 401(k) plan, but you can only contribute $7,000 to an IRA in 2024 unless you’re at least 50 years old, in which case the limit is $8,000 in 2024. 

IRAs sometimes have early withdrawal penalties

If you have a traditional IRA and withdraw from the account before age 59 ½ , you’ll generally pay a 10% penalty and income tax. There are a few exceptions to this, like if you withdraw up to $10,000 for a qualified first-time home purchase or lose your job and withdraw to pay health insurance premiums, under certain conditions.

As we explained above, Roth IRAs are significantly more flexible when it comes to withdrawing your contributions before retirement—you can typically do this without paying taxes or penalties. But if your early withdrawal exceeds your contributions and you take out earnings, or if you had previously completed a Roth conversion, you may be subject to taxes and a 10% penalty when you file your taxes with the IRS.

Some IRAs have required minimum distributions (RMDs)

If you have a traditional IRA, once you reach age 72 (or 73 if you turn 72 after December 31, 2022) you have to start withdrawing at least a minimum amount of money each year—this is called an RMD. The amount you must withdraw is your account balance at the end of the previous year divided by the “distribution period,” which is based on your age and set by the IRS each year. You can also calculate your RMDs using this tool from investor.gov. Practically speaking, RMDs mean your earnings can’t compound in a traditional IRA indefinitely. This rule doesn’t apply to Roth IRAs, however. If you have a Roth IRA, you typically don’t have to take RMDs during your lifetime unless you inherited the account. 

The bottom line

IRAs can be a powerful tool for building long-term wealth. If you’re thoughtful about your contributions and only invest money you won’t need until retirement, the benefits of these accounts outweigh the drawbacks. 

We know choosing the right IRA can feel tricky, so we developed our IRA calculator to help you determine what kind of account is right for your specific situation. Just enter your filing status, income, and a few other details and we’ll help you figure out the rest. When you’re ready to start saving, Wealthfront offers traditional and Roth IRAs, as well as SEP IRAs and rollover IRAs so  you can save for retirement on your own terms. 

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Disclosure

The information contained in this communication is provided for general informational purposes only, and should not be construed as investment advice. Nothing in this communication should be construed as an offer, recommendation, or solicitation to buy or sell any security.  Any links provided to other server sites are offered as a matter of convenience and are not intended to imply that Wealthfront Advisers or its affiliates endorses, sponsors, promotes and/or is affiliated with the owners of or participants in those sites, or endorses any information contained on those sites, unless expressly stated otherwise.

The information provided about Individual Retirement Accounts (IRAs) is based on the latest guidelines available for the year 2024. Please be aware that the IRS updates contribution and deduction limits, income thresholds, and other relevant regulations annually. These updates may affect the applicability of the information provided here in subsequent years. Additionally, while automation can streamline certain processes like Roth conversions, individual financial circumstances vary significantly. The effectiveness and suitability of these strategies depend on personal tax situations and investment profiles, which are unique to each investor.

This IRA calculator is offered by Wealthfront Software LLC (“Wealthfront”). 

This IRA calculator is for illustrative purposes only. You should not rely on this IRA calculator as the primary basis of any investment, financial, or tax planning decision. Nothing on this page should be construed to be a recommendation by Wealthfront or any of its affiliates that you take a particular course of action. This IRA calculator relies on assumptions that will not be representative of each individual who uses this tool. No representations, warranties or guarantees are made as to the accuracy of any suggestions provided by the IRA calculator.

Wealthfront Advisers and its affiliates do not provide legal or tax advice and do not assume any liability for the tax consequences of any client transaction. Clients should consult with their personal tax advisors regarding the tax consequences of investing with Wealthfront Advisers and engaging in these tax strategies, based on their particular circumstances. Clients and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the investor’s personal tax returns. Wealthfront Advisers assumes no responsibility for the tax consequences to any investor of any transaction.

Investment advisory services are provided by Wealthfront Advisors , an SEC-registered investment adviser, and brokerage products and services, are provided by Wealthfront Brokerage LLC, member FINRA / SIPC. Wealthfront Software LLC (“Wealthfront”) offers a free software-based financial advice engine that delivers automated financial planning tools to help users achieve better outcomes.

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About the author(s)

Tony Molina is a Product Evangelist at Wealthfront. He is a Certified Public Accountant (CPA) and holds Series 66 and Series 7 licenses from FINRA.

Related tags

IRA, Roth IRA, Traditional IRA