What is an IRA?

If you have ever researched retirement savings, you have likely heard of an individual retirement account (IRA). These accounts are retirement accounts individuals and couples can open at the financial institution of their choice.

There are several different types of individual retirement accounts. We’ll cover the following types here:

  • Traditional IRA
  • Roth IRA
  • SEP IRA
  • Simple IRA

There are a number of reasons you might open an IRA, such as to boost retirement savings. There’s much more to it than that, though. This post will explore the details of individual retirement accounts and help determine whether you should open one.

What Is An IRA?

An individual retirement account (IRA) is a tax-advantaged retirement account. IRAs have several advantages and you can open one almost anywhere. Plus, you can invest in any set of investments you want.

This is in contrast to employer-sponsored retirement plans, such as a 401k, which usually chooses your investment provider for you and limits you to certain investments.

Why Open an IRA?

IRAs have several advantages. They vary based on the type of IRA, but, generally, here are why they are beneficial:

  • Reduce taxable income. IRAs will allow you to reduce your taxable income, either when depositing or withdrawing.
  • Flexibility. IRAs allow you to invest in almost anything you choose. Employer-sponsored retirement plans often limit your investment choices.
  • Tax-free growth. Growth of IRAs is not taxed, allowing your money to grow tax-free. This eliminates the need for tax-loss harvesting for these accounts.

Types of IRAs

As mentioned, there are many different types of IRAs. Let’s take a closer look at each type.

Traditional IRA

A traditional IRA allows you to contribute tax-deductible dollars into an account that also grows tax-free. You then pay tax when taking distributions from the account. This arrangement makes sense if you expect your taxable income to be lower in retirement and/or that tax rates will be lower in the future because withdrawals are taxed as income.

As an example, if your income in retirement is lower than it is today and tax rates stay the same, you’ll pay less income tax overall. That’s because you:

  • Reduced taxable income today, when your income is higher
  • Opted to pay taxes in retirement, when you’ll be in a lower tax bracket

Because this is a retirement account, the idea is to not withdraw before age 59 & ½. If you take distributions before then, you will incur a 10% penalty (with some exceptions).

In addition, you must begin withdrawing the minimum amount at age 70 & ½ or 72, depending on your birthday. This is known as a required minimum distribution (RMD).

The 2021 contribution limit for traditional IRAs is $6,000, or $7,000 for those 50 and older.

Roth IRA

A Roth IRA works the same as a traditional IRA, but there are several differences. The most notable difference is when you pay taxes.

With a Roth IRA, you pay taxes when money goes in. You can then withdraw your money tax-free.

Another important difference with the Roth IRA is that there are no RMDs. Plus, you can withdraw before 59 & ½ without a penalty.

However, there are income limits for Roth IRAs. In 2021, the income limit is $140,000 for modified adjusted gross income (MAGI) for single people. For joint filers, the limit is $208,000.

As with the traditional IRA, money in a Roth IRA grows tax-free. The contribution is also the same, at $6,000 (or $7,000 for those 50 and over).

SEP IRA

Typically, self-employed people with no employees will open a simplified employee pension (SEP) IRA. Since self-employed individuals will often not have an employer-sponsored retirement plan, they likely need more than just a Roth a traditional IRA.

Contributions are tax-deductible and also grow tax-free. The contribution limit for 2021 is 25% of compensation or $58,000, whichever is lower. There is no catch-up contribution and you must take RMDs starting at 72.

SIMPLE IRA

A SIMPLE IRA is for small business owners with fewer than 100 employees. Contributions are tax-deductible and grow tax-free. Distributions are taxed as income, much like a traditional IRA.

The contribution limit for 2021 is $13,500, or $16,500 for those 50 and older.

How to Get Started

Opening an IRA is easy – many financial institutions have at least some options for them. For example, you can open one at M1 Finance or Vanguard.

You may also have the option to open an IRA with your credit union if you prefer.

If you don’t want to manage everything on your own, you can open one in a robo-advisor such as Betterment. Another robo-advisor, blooom, focuses specifically on retirement accounts.

Indeed, there is no shortage of ways to open an IRA. For more robo-advisors that support them, see our list of the best robo-advisors.

IRA FAQ

There are plenty of common questions about individual retirement accounts. Let’s address a few of them here.

Is an IRA and a 401k the Same Thing?

While both an IRA and a 401k are retirement accounts, they are not the same. The word “individual” gives us a clue: a 401k is an employer-sponsored retirement plan while an IRA is one an individual opens.

A traditional IRA and 401k are similar in the sense that you don’t have to pay taxes as it goes into the retirement account.

However, we say that traditional IRA contributions are tax-deductible because you will typically fund them with after-tax dollars. You then have the option to deduct the tax on your contributions on your tax return.

401k accounts, on the other hand, have the advantage of payroll deductions. Normally, your employer will withhold tax dollars from each paycheck as income tax. But if you fund your 401k in the form of payroll deductions, you can have your employer send that money directly to your retirement account without withholding.

Thus, a 401k is slightly more efficient since you are able to immediately reduce your taxable income instead of waiting until you file your return.

Can You Lose Money in an IRA?

An IRA is an investment account, so you can certainly lose money in it. But you have complete control over your investments which means you can adjust them according to your risk tolerance.

If you wanted to, you could leave your funds in a money-market account. These accounts are very low-risk investments that pay a modest interest rate.

Money-market accounts aren’t a great way to grow your wealth, but the point is that you can adjust your investments to whatever makes you most comfortable. If having your IRA in 100% stocks makes you queasy, you can add some bonds or, indeed, put some of it in a money-market fund.

The post What is an IRA? appeared first on Modest Money.