What Is an Individual Retirement Account (IRA)?
There’s a reason why saving for retirement is such a prominent priority for people from all walks of life: It’s the most important way to ensure you have enough money to enjoy a standard of living that’s comfortable for you after you leave the workforce. It’s never too early (or too late) to start looking towards your financial future, and one of the most effective tools for helping you start saving is an individual retirement account, or IRA.
There’s a wide variety of advantages to investing in an IRA as part of your retirement-planning strategy. These accounts are ideal if you don’t have access to an employer-sponsored retirement plan, and there are also some helpful tax benefits associated with putting your money into an IRA. As you get started in your journey towards a financially secure retirement, learn more about what IRAs are and how they work to determine whether they may be an appropriate investment option for you.
How Do IRAs Work?
There are several types of IRAs, but they function in a relatively similar way. Like a savings account, an IRA is an account that you deposit money into. But instead of merely sitting there earning a small amount of interest like a typical savings account would, the money you put into your IRA is actively invested in financial products like stocks, bonds, certificates of deposit and various other assets that have a much higher likelihood of earning you much higher returns. These profits grow over time, eventually providing you with enough money you can use to fund your lifestyle during retirement.
As mentioned, there are several different types of IRAs you can choose from. Their differences largely lie in the ways they’re taxed and the restrictions they carry.
- The traditional IRA is the most common type. It’s designed for anyone to use. The money you deposit into a traditional IRA isn’t taxed until you begin withdrawing funds from the account during retirement. This means the taxable income you’re earning right now is reduced by the amount you add to the IRA each year.
- Roth IRAs also offer tax savings, but the difference is that your deposits into them aren’t tax deductible while you’re still working. Instead, you don’t pay taxes on the amounts you withdraw from the account when you’re retired.
- Simplified employee pension (SEP) IRAs are designed for self-employed people and small business owners who have few (or no) employees. Their contribution limits are much higher than those for Roth and traditional IRAs.
- A savings incentive match plan for employees (SIMPLE) IRA is also designed for self-employed individuals and small business owners. The difference between SIMPLE and SEP IRAs is that employees are allowed to make their own contributions to SIMPLE IRAs but not to SEP IRAs.
Unlike 401(k)s, which are primarily (though not always) sponsored by employers, just about any adult can open and begin funding an IRA. However, there are a few different ways to open an IRA (and different institution types at which you can open them), so you’ll need to determine whether you want guidance about more hands-on investing or you’d rather “set it and forget it” when it comes to how your money is invested.
Banks and brokerages — both online and in person — give you more control in the decision-making process. But, if you’re less interested in participating, you can also use what’s called a robo-advisor service, which involves allowing an artificial intelligence program to make vetted investment choices on your behalf based on complex algorithms. Other than that, opening an account is relatively easy: You’ll need to provide some personal details — such as your Social Security number, birthdate and employment information — and fund the account.
Rules for IRA Deposits and Withdrawals
Once your IRA is open, you’ll need to follow some key rules to ensure you don’t face any penalties. IRAs have limits to the amounts of money you can deposit each year, and they also have rules about when and how you’re allowed to start withdrawing money.
One governing principle to remember is that IRAs are intended to create money for your retirement by investing your earnings. The funds you deposit are meant to stay there for the long term. Thus, you’re not permitted to begin withdrawing money from your IRA until you reach an age that’s closer to that at which people typically start retiring — at least not without paying extra for it. You can begin taking regular withdrawals from any type of IRA once you reach age 59 ½; if you withdraw money before you reach that age, you’ll end up paying a 10% early withdrawal penalty.
You have a level of flexibility in deciding how much you want to contribute each year to your IRA, but each account has an annual contribution limit. This limit is a federal one, and it can change from year to year. As of 2021, the limit for traditional and Roth IRAs is $6,000. Adults who are age 50 and over are allowed to make what’s called a catch-up contribution, which allows them to deposit an extra $1,000 into their IRAs for a total contribution limit of $7,000 annually. SEP and SIMPLE IRAs have different contribution limits.
How Are IRAs Taxed?
As mentioned, there are serious tax advantages to contributing to IRAs, but the differences in tax circumstances and associated benefits depend on the type of IRA you choose. In a traditional IRA, the money you contribute reduces the amount of taxable income you have for the year during which you contribute it. If you earn $75,000 this year and contribute the maximum $6,000 to your IRA (assuming you’re under age 50), your taxable income, barring any other deductions, becomes $69,000. Once you start withdrawing traditional IRA funds during retirement, you’ll pay taxes on them based on the tax bracket you’re in at that time. SEP and SIMPLE IRAs work the same way when it comes to taxation.
When you make contributions to a Roth IRA, your contribution is still counted as taxable income for the year when you make the contribution. For example, say you make a $6,000 contribution to your Roth IRA after earning $75,000 this year. Your taxable income will still be $75,000, barring any other deductions. But, once you retire, you won’t pay taxes on the withdrawals you take from the account.
Selecting the type of IRA that’s right for you is a serious and personal decision. If you’re unsure which account may be ideal for your situation, it can be helpful to consult with a trustworthy financial advisor for guidance.