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What Is An IRA And How Does It Work?

Molly Grace13-minute read
April 19, 2022

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An individual retirement account (IRA) is a tax-advantaged account that you use to save money for retirement. Unlike a 401(k), which is specifically an employer-sponsored retirement plan, an IRA can be opened by anyone, making it a great choice for individuals who are self-employed or whose employers don’t offer a work-sponsored retirement plan. Even if you already have an employer-sponsored retirement savings account, you can still choose to open an IRA on your own to further boost your retirement savings.

IRAs can be an important part of a retirement plan and may even be necessary, depending on your plan. While many workers assume that they’ll rely heavily on Social Security, these benefits are typically not sufficient as your only source of income in retirement – according to AARP, the estimated average Social Security retirement benefit in 2020 is $1,503 per month.

This means that saving for retirement is vital, no matter how far off it may seem to you.

There are a variety of different types of IRAs that people can use to plan for how they’ll support themselves in retirement. Read on to learn more about them and determine which option is the right one for your future.

What Is An IRA?

An IRA is a tax-advantaged investment portfolio. What does that mean?

With regular investment accounts, the IRS has rules for how they must be taxed, and you’ll typically pay taxes on any money you generate from those investments. Tax-advantaged accounts, such as those you use to save for retirement or some accounts that parents use to save for their child’s college tuition, allow investors to avoid certain taxes and even contribute pre-tax income if they choose.

How To Invest In An IRA

To open an IRA, you’ll need to go to a financial institution that offers them. These days, there are plenty of options for even newbies to easily open an account. Many online brokerages and robo-advisors make it easy and do a lot of the work for you, so you don’t need to have extensive investment knowledge to have a strong portfolio.

Almost anyone can open an IRA account, though what types you’re eligible for depends on certain factors. To be able to contribute to an IRA, the main requirement is that you have some form of taxable compensation. Note that we didn’t say taxable income, because not all income can be contributed to an IRA. For example, you aren’t allowed to use money earned from an investment property to contribute to your IRA.

Income that is eligible for IRA contributions includes compensation that you receive from working (including your wage or salary, plus any tips or bonuses you earn), commissions, self-employment income, alimony or separate maintenance (in certain cases) and nontaxable combat pay.

Eligibility, restrictions, limits and penalties all vary depending on what type of IRA you have, so let’s take a look at each one.

What Is A Traditional IRA?

A traditional IRA is a tax-deductible retirement account. What this means is that you can deduct any contributions you make on your taxes for that year, effectively lowering your taxable income.

It’s important to note that although you’re getting a tax deduction now, you will have to pay taxes on that money eventually. Once you retire and start receiving regular distributions from your traditional IRA, you’ll pay taxes on the money as you would any other income; how much you’ll pay will depend on which tax brackets apply to you.

This is where the difference between traditional and Roth retirement accounts becomes so important; with a traditional account, you get to save the tax-free income now and pay taxes on it later, and with a Roth account, you pay taxes now and get tax-free income in retirement. When deciding which one makes the most sense for you, you should think about whether you’ll have a higher income (and thus, larger tax burden) in retirement than you do right now

Traditional IRAs also have rules for how and when you can withdraw money, as well as a minimum distribution requirement.

Traditional IRA Contribution: Rules And Limits

There are three important rules and limits for traditional IRA contributions.

Withdrawal Limitations

While these accounts have some exceptions for making withdrawals before the allowed age (59½), in most cases if you take an early withdrawal, you’ll not only pay regular income tax but an additional 10% penalty on the withdrawal.

Maximum Yearly Contribution

The amount of money you contribute to an IRA is limited each year. These limits can change, but in 2021, you can contribute a maximum of $6,000 to an IRA. If you’re 50 or older, you can contribute a maximum of $7,000 in 2021.

Distribution Requirement

Traditional IRAs also have what’s called a required minimum distribution, which is the minimum amount you have to withdraw from the account each year after you reach a certain age. The age at which you begin receiving required minimum distributions is 72.

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What Is A Roth IRA?

A Roth IRA is a type of retirement account that was originally created in 1997. The name of the account came from the primary sponsor of the bill, Senator William Roth.

With a Roth IRA, you can contribute to your retirement savings to take advantage of tax-free growth. Before you put any money into your Roth IRA, you’ll pay income tax on that contribution. Once you hit retirement age, you’ll be able to withdraw the funds without paying any penalties.

If you have reason to believe that you’ll have a higher tax rate in retirement, a Roth IRA may make more sense for you. With a Roth IRA, you contribute after-tax dollars and you don’t get a tax deduction on contributions. Then, when you enter retirement and make withdrawals from the account, you get to do so tax-free.

Roth IRAs also have a bit more flexibility when it comes to withdrawals, which can make them a more attractive choice than a traditional IRA for some.

Roth IRA Contribution: Rules And Limits

Just like traditional IRAs, Roth IRA contributions also have rules and limits in terms of withdrawals, yearly contributions and distributions.

Withdrawal Limitations

Because your Roth IRA contributions have already been taxed, you can take that money out of your account at any time without penalty (as long as you’ve had the account for at least 5 years).

Keep in mind, though, that you can only take out what you’ve already contributed. If the money has grown over the years due to compounding interest, that additional money is considered earnings, and you can’t withdraw it without penalty if you’re under 59½, with a few exceptions.

Maximum Yearly Contribution

For 2021, you can contribute up to $6,000 to your Roth IRA if you’re under the age of 50. If you’re 50 or older, then you’re allowed to contribute $7,000. However, you’ll need to make less than $125,000 as a single person or $198,000 as a married couple filing jointly to be eligible to make a full contribution.

Distribution Requirement

There’s no minimum distribution requirement on a Roth IRA, provided you’re the original owner of the account.

For accounts that have been inherited from someone who passed away, the rules are different and depend on whether you’re a spouse or nonspouse. For example, a spouse can treat the IRA as their own or transfer it into a preexisting or new IRA. Both spouses and non-spouses can receive a lump-sum distribution or spread distributions out over a 5-year period, with all assets withdrawn within the 5 years.

The Big Difference Between Roth IRAs And Traditional IRAs

Is a Roth or traditional IRA better for you? That largely depends on when you want the tax break that comes with an IRA.

If you want the tax break now, a traditional IRA is the better choice. If you want that break during your retirement years, go with a Roth IRA. While the tax break with a traditional IRA may be beneficial now, it won’t provide you more money in the future, when you may need it more. With a Roth IRA, you’ll be able to receive all of the money you saved, not just a percentage of it after taxes are taken out. 

It also depends on if you want or need to withdraw from the account early. With a Roth IRA, you can take money out of the account without penalty – as long as you’ve had the account for at least 5 years and the money you take out is the money you contributed. If you withdraw money from a traditional IRA, you’ll pay a penalty of 10% of the amount you withdraw. The money you take out will also be taxed.

When comparing IRAs, it may be helpful to see a side-by-side comparison:

IRA Limits And Rules

Traditional IRA

Roth IRA

Withdrawal Limitations

Yes, age 59½

No, restrictions apply

Early Withdrawal Penalty

10% penalty and tax

None

Max. Yearly Contributions

$6,000; or $7,000 if 50+

$6,000; or $7,000 if 50+

Tax-Deductible Contributions

Yes, restrictions apply

No

Min. Distribution Required

Yes, at age 72

No

Tax-Free Distributions

No

Yes

It may be helpful to speak to a financial advisor to find the best option for your individual situation and retirement goals.

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Additional Types Of IRAs

Traditional and Roth are the two main types of IRAs available to individuals; however, there are several other types that might be better suited to particular situations. Let’s take a look at some of these options.

SEP IRA

SEP IRAs are a good choice for small business owners or self-employed individuals. A SEP, or simplified employee pension, is a tax-deferred retirement account, meaning that contributions are tax-deductible. With a SEP, contributions are made by the employer, not the employee. These plans allow flexibility for businesses in how much they contribute each year, depending on how well the business is doing in a given year. Employers have to contribute equally to each employee’s SEP, and can contribute up to 25% of the employee’s compensation or $57,000, whichever is less. The same limits apply to self-employed individuals contributing to their own SEP.

SIMPLE IRA

A Savings Incentive Match Plan for Employees, or a SIMPLE IRA, is another option for small-business owners or self-employed individuals. In fact, it’s specifically aimed at small businesses with 100 or fewer employees.

With a SIMPLE IRA, an employer is required to contribute a certain amount each year to all employees’ savings. There are two ways employers can structure their contributions: as a match, where the employer must match employee contributions up to 3% of the employee’s total compensation, or as a “nonelective contribution,” where the employer provides a contribution equal to 2% of the employee’s compensation, regardless of whether the employee contributes to their plan or not.

In 2021, employees can contribute up to $13,500 to their SIMPLE IRA. If you’re self-employed, you can contribute up to this amount plus either the 2% fixed contribution or the 3% matching contribution.

Rollover IRA

Say you have a tax-deferred retirement account (such as a 401(k)) with your employer, but you end up leaving your job. What happens to that money? You typically have a few options in these situations, one of which is to use a rollover IRA.

A rollover IRA allows you to move money from one tax-advantaged retirement account to another without losing the tax benefits the account offers or having to pay taxes or penalties on the funds.

Generally, you can rollover any pretax retirement account into all of the IRAs we mentioned, but be sure to speak with your tax advisor for more information specific to your situation.

Investment Strategies And Your IRA

One thing that makes an IRA such a great retirement asset is that it’s relatively versatile in terms of the types of investments you can hold in it. In fact, there are only a few things that IRAs can’t be invested in, including life insurance and collectibles (such as art or antiques).

An IRA can hold investments in many different types of assets, including stocks, bonds, mutual funds or even real estate.

Your ideal asset allocation – meaning the balance of different investments you have in your portfolio – will depend on your own financial goals and your tolerance for risk. Typically, younger people are advised to have a slightly more aggressive investing strategy, since they have a longer time to save and can usually weather dips in the market, while those approaching retirement age might want to play it a little safer and keep their investment strategy a little more conservative.

If you have no idea how to create an investment strategy, no sweat. Online brokerages and robo-advisors typically have plenty of resources on how to get started and can even help you make selections based on some basic information about your financial goals. Or, if you want to talk to someone in person, you can also find a local brokerage firm to figure out what your strong IRA portfolio would look like.

Factors To Consider When Choosing An IRA Type

Both Roth IRAs and traditional IRAs have pros and cons. The right choice will depend on your situation. As you weigh your options, consider the following factors.

Your Current Age

One of the biggest factors in choosing the right retirement account is your current age.

If you are older or plan to contribute to your IRA into your 70s, then a Roth IRA is likely the better choice. At 70½, you’ll run into required minimum distributions with a traditional IRA that could negatively affect your retirement plans.

Your Eligibility

If you’re young and in a low tax bracket, a Roth IRA likely makes more sense. If you have matured into your high-paying career, a traditional IRA might be the better option to lower your taxable income for the current year. The income limits will likely affect your choice between these two retirement accounts.

Your Future Needs

Finally, you’ll need to consider the plans that you have for these funds. Consider how much money you’ll need to retire and how you’ll be able to reach your goals within both retirement accounts. If you plan on earning more or less income in retirement, then you can adapt your tax strategy appropriately.

IRA FAQS:

Can You Lose Money When Investing In An IRA?

No investment comes without risk; IRAs are no exception. Depending on the performance of the stock market and the overall economy, the value of the investments in your IRA might rise or fall. It's normal for the value of your IRA investments to fluctuate. But IRAs are a long-term investment. What matters most is the value of your investments as you near retirement age. This is why many reallocate their IRA investments to safer, less volatile stocks and bonds as they get closer to their retirement day.

Are Iras And 401(k)s The Same Thing?

No. A 401(k) plan is offered by your employer, while you take out an IRA on your own. You have the option of devoting a percentage of each paycheck to your 401(k) as a way to build money for retirement. A 401(k) also has different limits on how much you can contribute each year: $19,500 in 2020 unless you are 50 or older, in which case you can contribute a maximum of $26,000 annually. Your employer might also offer matching contributions that will help you build the savings in your 401(k) at a quicker pace.

When Can You Withdraw Money From Your IRA?

You can take money out of your IRA whenever you'd like. Whether you incur penalties will depend on if you have a traditional IRA or a Roth IRA and how long you’ve had the account.

Taking money out of your traditional IRA too soon, though, will result in a costly penalty. Once you turn 59½, you can withdraw money from your traditional IRA without any penalties. But if you take money out before that age, you will pay a penalty of 10% on the amount you withdraw. You'll also have to pay income taxes on withdrawals because the IRS considers these to be forms of income. You are required to make regular withdrawals from your traditional IRA once you hit the age of 72.

You can take money out of a Roth IRA with no penalty as long as you’ve had the account for at least 5 years and withdraw only money you’ve contributed.

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Molly Grace

Molly Grace is a staff writer focusing on mortgages, personal finance and homeownership. She has a B.A. in journalism from Indiana University. You can follow her on Twitter @themollygrace.