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What is an IRA and How Does it Work

What is an IRA?

An individual retirement account (IRA) is a tax-advantaged account that allows individuals to save and invest for retirement. Unlike a 401(k), this type of account can be created individually without employer sponsorship. However, you can still have an IRA even if you have a retirement plan through your employer.

You can open an IRA through a bank or other financial institution, a personal broker, or an online brokerage. 

Key Takeaways

  • An IRA is a tax-advantaged retirement account available to individuals and small businesses.
  • There are several types of IRAs: traditional, Roth, Rollover, SIMPLE, and SEP.
  • Annual contribution limitations apply to all types of IRAs.
  • You can have an IRA in addition to a 401(k).

How does an IRA work?

Anyone with earned income can open an IRA. You may have an IRA in addition to an employer’s 401(k) or other retirement plan. An IRA works by investing the money saved in the account in various financial products, such as stocks, bonds, exchange-traded funds (ETFs), and mutual funds. There are several types of IRAs, and the rules and tax advantages vary by type.  As always, there are income limitations on IRA eligibility.

Types of IRAs

Traditional IRA

Contributions to a traditional IRA are generally tax-deductible, meaning if you contributed $2000 to your IRA in one year, your taxable income would decrease by that amount.

Your contributions then grow on a tax-deferred basis, meaning when you withdraw in retirement, you will be taxed at your regular income tax rate for that year. All IRAs have annual contribution limits. These income limits change yearly and can be found on the IRS website here.

Roth IRA

Roth IRA contributions are not tax-deductible, but the distributions taken once in retirement are tax-free. This means you contribute to a Roth IRA with post-tax income, and do not pay any further taxes, even on investment gains. 

Additionally, Roth IRAs do not have required minimum distributions (RMDs), so if you do not need the money at the start of retirement, you can leave it in the account where it can grow tax-free. 

Rollover IRA

A rollover IRA is designed to hold funds transferred from an employer-sponsored retirement fund. This allows you to consolidate savings from past jobs into one account.  

When done correctly, you can avoid immediate taxes and early withdrawal penalties you may have faced for simply taking the funds out of the original account. This may not apply if, for example, you roll over a traditional 401(k) into a Roth IRA. It is best to consult a professional to avoid penalties or unexpected taxes, especially if your account has a high balance.

SIMPLE IRA

A SIMPLE (Savings Incentive Match Plan for Employees) IRA allows small businesses to offer a retirement matching plan for employees, as they do not have the high start-up and operating costs of traditional retirement plans. Companies with 100 or fewer employees generally use it. 

Currently, the employer is required to either:

  1. Match contributions up to 3% of employee compensation, or
  2. Provide a 2% non-elective contribution for each eligible employee. This means that even if the employee chooses not to contribute to the IRA, the employer still must make contributions of 2% of the employee’s annual income, up to the yearly limit.

Contribution limits change by year, so it is best to check the IRS website for updated information.

SEP IRA

A SEP (Simplified Employee Pension) IRA allows employers to contribute to a traditional IRA set up for employees. Any business, regardless of size, or anyone self-employed may have an SEP IRA. A SEP IRA is funded only through employer contributions, and the employer must contribute equal percentages of income for all eligible employees.

Business owners (or yourself, if self-employed) may deduct contributions for tax purposes. Withdrawals from SEP IRAs are taxed as regular income.

IRA Benefits

An IRA offers a flexible and tax-advantaged way to save for retirement. There are several benefits. You can have an IRA and an employer plan, allowing for more tax-advantaged annual savings. They provide small businesses with retirement planning options, as SIMPLE and SEP IRAs do not come with the hefty fees and start-up costs of traditional plans.

IRAs also allow self-employed individuals to access the tax advantages of retirement accounts. 

Contribution Limitations 

All IRAs come with annual contribution limits. These limits change, but for 2024 and 2025, the current limits are no more than $7,000 ($8,000 if over age 50) or, if your income is less than that, your taxable compensation for the year. 

How to Open an IRA

You can open an IRA through an online brokerage, mutual fund company, or bank. Where to open an IRA depends on your individual needs. 

Bottom Line

IRAs are an important tool in retirement planning. If you are unsure what your best choice is, Horizons Wealth Management can help advise you with fee-only financial services. As fiduciaries, we focus on client-centered relationships that will give you peace of mind on your financial journey. 

Individual Retirement Account FAQ

What does “IRA” stand for?

IRA stands for Individual Retirement Account.

Can you lose money in an IRA?

It is possible, given a diversified portfolio.

How much does it cost to start an IRA?

Opening an IRA does not cost anything, but some require a minimum initial deposit. Some brokers charge trading commissions, or if you invest in mutual funds or ETFs, you’ll have to pay an expense ratio. However, these fees are generally not very high.

Is an IRA or 401(k) better?

An IRA is not better than a 401(k), just different. You may have an IRA in addition to a 401(k). If you do not have access to a 401(k) or similar plan because your employer does not offer one, or you are self-employed, an IRA is a good choice.

Are there age restrictions to open an IRA?

There is no minimum age to open an IRA. However, a parent must open a custodial account for a minor until the child is 18 and they still need earned income.

What is the best way to grow an IRA?

The best way to ensure growth in an IRA is to begin investing as early as possible, so the funds have the most time to grow before retirement. As long as IRA investments are diversified, it is unlikely to incur a loss.

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Inheriting a 401K – Rules and What To Do

If you inherit a 401(k) from a spouse, parent, or loved one, itis essential to be prepared. Inheriting this type of account may be less straightforward than other types of inheritances, and comes with many considerations depending on your relationship to the account holder. 

The IRS has specific rules for spousal and non-spousal beneficiaries, all of which can affect your financial outcomes. Depending on the 401(k) type, you may owe taxes on the distributions from the inherited account. If you’re the beneficiary of a 401(k) or will be in the future, here’s what you need to know.

Key Takeaways

  • Inherited 401(k) rules have key differences between spousal and non-spousal beneficiaries. 
  • You will owe standard income taxes if you inherit a traditional 401(k).
  • You will not owe income tax if you inherit a Roth 401(k).

What is a 401(K)

A 401(k) is an employer-sponsored retirement savings plan. There are two types of 401(k) plans, traditional and Roth. With a traditional 401(k), employee contributions are pre-tax, reducing your taxable income, and taxes are paid when withdrawals are made during retirement. For Roth plans, contributions are made with after-tax dollars, but withdrawals in retirement are tax-free.

401(k) plans can be a great asset in retirement savings and should be taken advantage of if offered by an employer. 

What are the rules when you inherit a 401(k)?

The rules for inheriting a 401(k) depend on several factors, including your relationship to the account holder, the age of the owner at their time of death, and whether or not they began taking required minimum distributions (RMDs), which start at 73. Detailed below are considerations for the most common situations.

How inheriting a 401(k) from your spouse works

If you inherit a 401(k) from a spouse, there are four options to consider: 

  • Take a lump-sum distribution. This means you can receive your portion of the 401(k) as a lump sum, without penalty. The IRS considers these distributions as regular income, which can create a significant tax bill. This is generally only a good option if the account balance is relatively small or you need immediate access to the full amount.
  • Roll the assets into your own 401(k) or IRA. This option allows you to treat the funds as if they were originally your own, consolidating your savings into one account. It also provides the opportunity for the funds to continue growing. Rollovers are subject to standard 401(k) or IRA rules, but do not incur any unique penalties. If pre-tax funds are rolled over into a Roth account, you will most likely be subject to tax penalties. It is best to consult a financial or tax advisor if you are considering a Roth rollover. This benefit is only available to spousal beneficiaries.
  • Transfer the 401(k) funds into an inherited IRA. An inherited IRA is an individual retirement account made specifically for inherited funds. This type of account allows the beneficiary to take withdrawals without facing early withdrawal penalties. It requires that you take minimum distributions, but these are based on your life expectancy, not your spouse’s. This option is helpful for spouses under 59½ who would like to make immediate withdrawals.
  • Leave the 401(k) as is. If you leave the 401(k) in its original plan, you may withdraw without triggering the 10% early withdrawal penalty. You will still pay income tax on any tax-deferred funds. If you are over 59½ and your spouse was over 73 and taking RMDs before they passed away, you may choose to continue the withdrawals or wait until you reach 73 to begin RMDs. If you are 73 or over, you must take RMDs. If you are between 59½ and 73 with a spouse who was not yet 73, you can begin taking RMDs when your spouse would have reached 73.

Options for an Inherited 401(K) if you’re a non-spouse beneficiary

Options for an inherited 401(k) vary if you are a non-spouse beneficiary. In this situation, your options are:

  • Take a lump-sum distribution. This option is the same as if you were a spouse. If you choose to take a lump sum, knowing if this distribution would push you into a higher tax bracket and being prepared is important. If the inherited 401(k) is traditional, you will owe taxes at standard income rates; if it is a Roth, you won’t owe any additional taxes on the withdrawal.
  • Transfer the 401(k) funds into an inherited IRA. Money from an inherited IRA must be fully withdrawn within 10 years, unless the beneficiary is qualified as an eligible designated beneficiary, such as a minor child or someone with a disability. If the money in the 401(k) was pre-tax, you will owe taxes on withdrawals from a traditional inherited IRA. If it is withdrawn from a Roth 401(k) or converted to a Roth IRA, taxes will not be owed, as the money was contributed post-tax. If you convert a traditional 401(k) into an inherited Roth IRA you will most likely incur taxes on the conversion.
  • Leave the 401(k) as is. You can leave the funds in the original 401(k), but as a non-spousal beneficiary, they are also typically subject to the 10-year rule.

What if the inherited 401(K) is a Roth?

If you inherit a Roth 401(k), you will not owe taxes on withdrawals, as the money was originally contributed post-tax. However, you may still be subject to the 10-year rule.

401(K) 10 Year Rule

With the passage of the SECURE Act in 2019, most non-spousal beneficiaries are required to fully distribute the inherited account within 10 years, a provision known as the 10-year rule. 

  • If the account holder died in 2020 or later, non-spousal beneficiaries must withdraw all funds by the end of the 10th year of the account holder’s passing or be subject to a 50% penalty on all remaining funds.
  • There are some exceptions for non-spousal beneficiaries inheriting accounts in or after 2020. If the beneficiary is a minor, disabled or chronically ill, or is not more than 10 years younger than the original account owner, they may take RMDs based on their life expectancy. For minor beneficiaries, the 10-year rule applies when they reach the age of maturity, as determined by their state, typically 18 (or 19 or 21 in some states). For the other categories, the 10-year rule never applies.

Bottom Line

If you inherit a 401(k), you have several choices on handling the funds within the account. These options vary in terms of rules and regulations for spousal beneficiaries versus non-spousal beneficiaries. Since these inheritances can come with significant tax liabilities, it may be helpful to consult a professional. Horizons Wealth Management financial services can assist in understanding and managing an inherited 401(k). 

401(K) Beneficiary FAQ

Do beneficiaries pay taxes on 401k (k) inheritances?

It depends on the type of 401(k) inherited. If it is a traditional 401(k), yes, as the contributions were made initially on a pre-tax basis. If it is a Roth 401(k), no, as the contributions were made with post-tax income.

How to avoid beneficiary taxes on inherited money?

There is no way to entirely avoid taxes on an inherited traditional 401(k) besides disclaiming the inheritance. You can minimize taxes paid at once by taking distributions from the original 401(k) or transferring the funds to an inherited IRA and taking distributions over 10 years.

Can I convert an inherited 401(k) to a Roth IRA?

Yes, you can convert an inherited 401(K) but you will have to pay taxes on the conversion. 

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What’s the Difference between a Will and a Trust?

Wills vs. Trusts

Estate planning can be complex, as it combines the challenges inherent in managing an individual’s financial assets with the emotional challenges of navigating their final wishes before death. 

Fortunately, there is a vast range of options available for planning your estate, covering every imaginable combination of assets, beneficiaries, and liabilities.

Key Takeaways

  • Trusts and wills are two different types of documents used to settle a deceased individual’s estate.
  • While wills are typically simpler and cheaper to draft, a trust can offer additional benefits that may appeal to individuals with larger, more complex estates.
  • When establishing a trust, you’ll need to designate whether the terms are flexible or fixed, as well as whether the trust will exist while you’re still alive or be formed after your death.
  • No matter what form of estate planning you choose, it’s smart to have a plan for your assets in place long before you think it might be necessary.

What is a Will?

A will is a document that outlines how an individual wishes their estate to be handled after their death. Every will is different, but most will include some or all of the following details:

  • Executor – The executor of a will is the individual responsible for carrying out the deceased individual’s wishes, also known as the decedent. The named individual is expected to ensure the terms of the will are followed as closely as possible.
  • Beneficiaries – Beneficiaries are the recipients of the deceased person’s assets. This can include family members, partners, friends, or anyone else the decedent wishes.
  • Terms – In addition to naming recipients of the decedent’s assets, a will should also explain how the assets will be divided and what, if any, conditional terms they wish to place on the distribution of said assets.

Not all assets need to be included in a will—many financial assets, for instance, require the owner to name beneficiaries when creating the account or other financial arrangement. A will can cover the remainder of the decedent’s assets that do not already have named beneficiaries.

Tax Implications of Wills

The tax implications of an inheritance, no matter how it is structured, can be complicated. Most estates do not reach the threshold for triggering the federal estate tax—a tax levied on the distribution of estates totalling more than $13.99 million in 2025—and only a few states have estate taxes of their own.

Inheritance taxes are also not universally applied and can vary from state to state. However, most places will levy capital gains taxes on inherited assets that have since matured and generated new wealth for their beneficiaries.

If you are unsure of your tax requirements for inherited financial assets, the IRS offers a convenient tool to determine your inheritance tax liability.

What is a Trust?

A trust is a legal and financial arrangement in which an individual, known as the grantor, entrusts the management of financial assets to a third party, known as a trustee, for the benefit of a beneficiary. While these types of arrangements are frequently used for estate planning purposes, trusts can also be utilized for other purposes. Individuals who are unable to manage their own finances or those with minor beneficiaries may also benefit from using a trust to manage their funds.

Types of Trusts

Not all trusts are the same, and which type of trust you employ in your estate planning process will largely depend on your unique financial circumstances and the beneficiaries you plan to name in the document. The following are some of the most commonly used types of trusts.

Living Trust

A living trust is created while the grantor is still alive, providing the grantor with considerable flexibility in how they would like their assets managed. In many cases, it also allows beneficiaries to avoid the often costly process of settling an estate through probate.  These trusts can be further broken down into two types of financial arrangements.

A revocable trust is an arrangement created by a living grantor that outlines the terms for dividing the grantor’s assets after their death. The trust is considered revocable if the grantor can alter or revoke the terms of the agreement. 

This type of trust is suitable for individuals who wish to transfer their assets to named beneficiaries; however, it has some drawbacks. Because the grantor still technically controls the assets while they are living, creditors may still have a valid claim to the assets if the grantor owes money or is targeted by lawsuits upon their death. 

In cases where a grantor has concerns about creditors pursuing their assets after their death, an irrevocable trust could be a better option. Once these types of trusts are established, their terms cannot be changed, making them a less flexible option than revocable trusts. The upside, however, is that they offer better asset protection from creditors who might seek to claim the grantor’s assets before they are transferred to the beneficiaries.

Testamentary Trust

Unlike living trusts, testamentary trusts are established after the grantor’s death—usually through terms outlined in the decedent’s will. While living trusts can be either revocable or irrevocable, testamentary trusts are always irrevocable, ensuring that the terms cannot be altered after the grantor is no longer able to participate in their implementation.

Testamentary trusts generally require less work on the part of the grantor and the trustee, as the document doesn’t require asset management until after the grantor’s death. They are also commonly used when the grantor wishes to distribute assets on a set schedule to minor beneficiaries or other individuals who need a more structured distribution of their assets.

The biggest drawback to this type of trust arrangement is that it doesn’t avoid the probate process in the same way certain living trusts can. Probate can be complicated and expensive in certain circumstances, so it’s important to consult with a professional before choosing which type of trust is right for you.

Charitable Trusts

Not all beneficiaries are friends and family members; in many cases, a grantor will choose to establish a trust to benefit a charitable organization. These types of trusts are always irrevocable, and can offer a variety of benefits to the grantor both during their lifetime and for their other beneficiaries after their death.

There are several tax benefits to establishing these types of trusts, and in most cases, they will generate income for both the charitable organization and other, non-charitable beneficiaries in the long term. The IRS has helpful pages on how charitable trusts work, along with their tax implications.

Special Needs Trusts

Many trusts are established to provide support to individuals who require additional assistance in managing their assets. In cases where a single, lump-sum inheritance could pose a hindrance to a given beneficiary, a special needs trust can help manage the grantor’s assets on their behalf. 

These trusts typically distribute a small portion of the assets contained in the trust to the beneficiary on a set schedule, creating a consistent income stream for them over time. Many special needs trusts are also designed to allow beneficiaries to continue receiving assistance from programs like Medicaid and Supplemental Security Income, as these trusts can be structured not to be counted toward the individual’s income level when determining eligibility for these government benefits.

Tax Implications of Trusts

The tax implications of trusts depend largely on the type of trust you establish, where you establish it, and who you name as beneficiaries. In many cases, the income received from your trust will be subject to income tax requirements for your beneficiaries. In some cases, your beneficiaries may need to pay capital gains taxes on some or all of the assets they receive.

Generally speaking, tax issues related to trusts are more complex than those involving wills. If you have questions about potential tax liabilities for your trust, Horizons Wealth Management can help guide you in the right direction. Get in touch today to learn more about financial planning, retirement planning, wealth management, and managed portfolio services.

Wills vs. Trusts: How to Choose

There is no one-size-fits-all solution for estate planning, and whether you choose a will or a trust to handle your affairs after your death will largely depend on the size and complexity of your estate, as well as the number of beneficiaries and how you wish for them to receive your assets.

Generally speaking, a will is a simpler option for managing your estate. They are cheaper to create, easy to interpret, and enable the job to be done quickly and simply for estates with uncomplicated finances and a small number of beneficiaries.

If, however, your estate is particularly large or consists of a more complicated arrangement of financial assets, it might be worth it to establish some trust. While they cost more to establish initially, trusts can help certain assets avoid the probate process. They may offer you and your beneficiaries a range of tax benefits not available to individuals managing their estate with a will.

Bottom Line

Before deciding to draft a will or form a trust, consider the size and structure of your estate. Do you know who your beneficiaries are, and how you’d like them to receive your assets? Do you anticipate creditors will come after your assets when you pass away? Are there important charities you wish to include in the distribution of your assets?

All of these questions can help guide you toward the right estate planning tools for your unique circumstances. Whether you decide to go with a will or some form of trust, having your estate plan in place can be a tremendous relief as you navigate the complicated process of allocating your assets for future generations.

Trust vs. Will FAQ

How Does Estate Planning Affect Unmarried LGBTQ+ Couples?

As with any other couple, married or otherwise, effective estate planning can help save a great deal of heartache and potential financial misfortune. Individuals do not need to be married or even in a romantic partnership to be named as a beneficiary or executor of an estate.

In certain states, the spouse of an individual who dies without any estate planning documents in place will be named the default executor. However, this convention varies from state to state. The best way to ensure your wishes are followed after you die is to establish an estate plan long before you think it might be necessary.

Are Wills or Trusts Needed If Beneficiaries Are Designated on an Account?

No, generally speaking, an account with designated beneficiaries will be distributed to those named beneficiaries regardless of what a will or trust might say to the contrary. It’s essential to ensure that the named beneficiaries across these accounts and your will or trust are consistent to avoid unnecessarily prolonging the probate process.

At What Net Worth Do I Need a Trust?

There is no hard-and-fast rule for how much money you need to have before a trust is required, although they are typically used in situations where estates have a higher net value and a larger number of assets to distribute. 

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How to Budget Like a Millionaire

Most millionaires aren’t driving Lamborghinis and eating caviar. They’re driving reliable used cars and eating mashed potatoes and meatloaf. Millionaires aren’t wealthy because they’re lucky. They’re wealthy because they follow simple money habits year after year.

Click HERE to learn more about Dave Ramsey’s 6 Surprising Habits of Millionaires. 

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How Cars Affect your Financial Freedom

It’s not that I don’t want a really fancy car, it is just that there is something I want a bit more: financial freedom. Car payments are many times the #1 obstacle that causes the average family not to achieve financial stability. Spend some time thinking about your current car situation.  Are your car purchases making your bank richer or you?

Here is a great read about “How Your Car Affects Your Financial Freedom.”

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5 Secrets of Self-Made Millionaires

Money Magazine shares their research on the success secrets of self-made millionaires.

Click here to read more.

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Warren Buffett and Bill Gates Agree – This Factor Was Most Important for their Success

Warren Buffett, Steve Jobs, and Bill Gates have all attributed their success to one factor. In fact, this one trait is behind the success of all people that have performed massively better than the average person.

Click here to find out what the trait is and how you can put it into practice in your own life and investing.

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