What is an IRA and How Does it Work?
Updated: Sep 7, 2021
An IRA is an investment account that provides tax breaks for retirement savings. Investing money in an IRA is one of the best ways to prepare for your later years because anyone with earned income can open one -- even those without access to an employer-sponsored retirement plan.
However, before you contribute to an IRA, you should have a sense of which type is right for your situation, and you should learn the rules for both deductible contributions and penalty-free withdrawals.
What is an IRA?
IRA stands for individual retirement account. There are several different types, but each allows you to make tax-advantaged contributions from income you earn to build a nest egg for retirement.
The different kinds of IRAs have different contribution limits, and some also impose income limits on contributors. For example, the two most commonly used IRAs -- traditional and Roth -- have an aggregate contribution limit of $6,000 in both 2020 and 2021, although those 50 or over can make an additional catch-up contribution annually. The catch-up contribution amount is $1,000 for both 2020 and 2021, so workers 50 and over could contribute a maximum of $7,000 each year.
IRAs can be opened with any financial institution, including:
Discount online brokers
Investment management firms
Once you’ve made a contribution, you can purchase any assets your brokerage allows, including stocks, bonds, and mutual funds.
Once you turn 59 1/2, you can begin withdrawals from this account. If you need the money earlier, you’ll be subject to a 10% penalty fee, unless you qualify for a special early distribution for a specific purpose, such as paying unreimbursed medical expenses.
Advantages of IRAs
IRAs have several advantages over other types of retirement accounts:
Contributions provide significant tax advantages: Traditional IRAs allow you to contribute to your account with pre-tax dollars, while Roth IRAs allow you to benefit from tax-free gains in retirement. You can choose whether to save on taxes now or in your later years.
You do not need an employer to open an IRA for you: Though there are a few types of IRAs that employers can offer for employees, you can set up the most common IRA account types (traditional and Roth) for yourself. You have the option to use an IRA as a supplement to a workplace savings plan, or you can open one to take advantage of tax breaks for retirement savings if your employer doesn’t offer a 401(k) or similar plan type.
You have more flexibility in investment options: You can choose from a wide variety of financial institutions to hold your IRA, including brokerage accounts, robo-advisors, and banks. These types of accounts also usually offer several different investments to choose from, so you can invest your money in a much broader variety of assets than would be available in a typical workplace 401(k) plan.
Most institutions allow you to open an IRA with no fees and no minimum balance: Many brokers and banks make it easy to get started investing, with few or no costs associated with opening or maintaining your account.
Types of IRAs
There are several different kinds of IRAs you can choose from. These include:
Traditional IRA plans allow you to invest pre-tax income toward your retirement. These contributions can grow tax deferred until you withdraw them, and they can be tax deductible, too. While anyone can contribute to this type of IRA (regardless of income), there are some restrictions.
You can deduct up to $6,000 in 2020 and in 2021 or $7,000 if you’re 50 or over (this is an aggregate limit for traditional and Roth IRAs). Contributions are also fully tax deductible if neither you nor your spouse has a workplace retirement plan. But tax deduction eligibility begins to phase out for higher earners.
Contributions to a Roth IRA are made with after-tax dollars. While contributions aren’t deductible in the year they’re made, this money grows tax-free and withdrawals aren’t taxed in retirement. Roth IRAs are also subject to the same aggregate contribution limit as traditional IRAs. Unlike traditional IRAs, Roth IRAs have income limits on who can contribute.
Simplified employee pension IRAs, or SEP IRAs, can be set up by small business owners or self-employed individuals. Only employers and the self-employed can make contributions to this type of account.
The annual contribution limit is the lesser of 25% of employee compensation, or $57,000 for 2020) and $58,000 for 2021. There are no income limits for contributing to a SEP-IRA. Contributions are deductible in the year they are made.
Just as with SEP-IRAs, employers and the self-employed can set up a SIMPLE IRA, but both employers and employees can contribute to this type of account. Employees may contribute up to $13,500 in 2020 and in 2021, with those 50 and over eligible to make catch-up contributions of up to $3,000 if their plan permits it. There are no income limits for contributions to SIMPLE IRA plans.
Disadvantages of IRAs
While IRAs can be a good means of saving for retirement, they have some drawbacks. Before you decide how to invest for retirement, consider how much these details matter to you:
With traditional and Roth IRAs, you are not provided with any employer match, unlike with some 401(k)s.
Usually you have to manage your IRA yourself, which means you must find a brokerage firm or other financial institution to hold the account, and you must choose your investments for your portfolio. While you can open your IRA with a financial institution that offers investment management, this can get expensive, which may eat into your savings.
You must make contributions to a traditional or Roth IRA yourself and report your contributions to the IRS for a traditional IRA. This is more complicated than simply having your employer withhold money from your paychecks, although most financial institutions offering IRAs allow you to set up automated contributions from your checking account.
You cannot withdraw the money from a traditional IRA until age 59 1/2 without incurring a 10% penalty, unless you qualify for a special withdrawal, such as to pay for large medical expenses that are not covered by health insurance. You can withdraw Roth IRA contributions at any time, but you have to wait until you’re 59 ½ to withdraw the earnings to avoid the penalty and income taxes in most cases.
How to open an IRA
Opening an IRA is as simple as establishing an account with a brokerage. Doing so takes only a few minutes, and should enable you to start investing for retirement within a few days of making your first contribution. Open Your Account Today and Get Free Stock
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