What Is an Individual Retirement Account?
An IRA, or individual retirement account, allows you to save money for your retirement while taking advantage of tax breaks. You can set up an IRA through a bank or other financial service provider and enjoy tax-free or tax-deferred growth of your retirement savings.
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- Published: September 17, 2020
- Updated: August 17, 2022
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What Is an IRA?
The term IRA is used to describe individual retirement accounts and the Internal Revenue Service’s broader definition of individual retirement arrangements.
An individual retirement account is a type of individual retirement plan that offers tax advantages for people saving for retirement.
Depending on the type of IRA you have, you may make contributions to the plan now, but not have to pay taxes until you withdraw money from the IRA. Or you may contribute after tax money now and have no taxes to pay on money you withdraw from the IRA after you retire.
You can contribute earnings each year up to a maximum amount allowed by the IRS.
Rolling Over Your 401(k) Into an IRA
IRAs are also an option to consider if you have accumulated money in your employer’s 401(k) plan and you leave your job, whether you are retiring or taking a new job. You may want to consider a rollover.
The term “rollover” describes a tax-free distribution or movement of your assets from one retirement plan to another. Moving the money into the second plan is called a “rollover contribution.”
You can choose to move the assets to your new employer’s retirement plan, leave them where they are, cash out your assets or roll them over into an IRA.
How IRAs Work
Unlike 401(k) plans, which are retirement accounts set up by your employer, IRAs are retirement plans that you set up on your own through a financial institution or advisor.
- Banks or other financial institutions
- Life insurance companies
- Mutual funds
- Stock brokerage firms
Once you open an IRA, you invest money into the IRA account. You can invest in stocks, bonds or other assets that can grow your investment. In the case of self-directed IRAs, you can even invest in alternative asset classes like cryptocurrency, tax liens and gold.
You can continue contributing to keep your IRA investments growing, but there is a maximum amount of money you can invest each year.
You can withdraw money from your IRA at any time, but if you do it before you are 59.5 years old, you can face a penalty equal to 10 percent of your withdrawals and get hit with a tax bill for the money you take out.
The Four Main Types of IRAs
There are several different types of IRAs, but most fall into one of four different types: Traditional, Roth, SEP or SIMPLE IRAs.
- Traditional IRA
- Contributions you make to a traditional IRA are usually tax-deductible and you pay no taxes on IRA earnings until you retire and withdrawals are taxed as your income.
- Roth IRA
- Contributions to a Roth IRA are made with after-tax money, so you can’t deduct them from your taxes. But your earnings and withdrawals are tax-free.
- SEP IRA
- SEP IRA contributions are typically set up by a small business or someone who’s self-employed. They allow contributions to a traditional IRA set up in the employee’s name.
- SIMPLE IRA
- SIMPLE (Savings Incentive Match Plan for Employees) IRAs are available for small businesses that don’t have any other type of retirement plan for workers. These allow employer and employee contributions that are similar to a 401(k) plan, but they are simpler and less costly to administer. They also have lower contribution limits.
|IRA Type||Who Can Set up This Type of IRA?||Employee Contribution Limits (2020)||Are Contributions Tax-Deductible?||Are Distributions or Withdrawals Tax-Free?|
|Traditional IRA||Individuals and married couples||$6,000 if you are younger than 50; $7,000 if you are 50 or older||Yes, If you qualify||No|
|Roth IRA||Individuals and married couples||$6,000 if you are younger than 50; $7,000 if you are 50 or older||No||Yes|
|SEP IRA||Small business owners and self-employed people||Either 25 percent of income or $57,000, whichever is less||Yes, but with the amount limited by law||No|
|SIMPLE IRA||Small business owners and self-employed people||$13,500 if you are younger than 50; $16,500 if you are 50 or older||Yes||No|
Why Should You Invest in an IRA?
Even if you already have a 401(k) or another employer-backed retirement plan, you can still set up an IRA, giving you another source of retirement income.
You may also want to invest up to the maximum amount each year to maximize your potential retirement savings. Talking to a licensed financial professional can help you understand what amount of contributions works best for your financial situation.
One of the biggest benefits of an IRA is that it allows you to invest while deferring taxes on the income you contribute until you withdraw the money. But you are only allowed to contribute certain types of income under the law.
Some parents and grandparents even choose to open custodial IRAs for their dependents, giving them the gift of tax-free growth on investment starting from a very young age.
- Disability retirement benefits received before minimum retirement age
- Nontaxable combat pay
- Self-employment earnings if you are a contractor meeting certain legal qualifications
- Self-employment earnings if you are a minister or member of a religious order
- Self-employment earnings if you own or operate a business or farm
- Union strike benefits
- Other taxable employment income
You can only invest earned income into an IRA. Under federal rules, you can’t use income sources that the IRS does not consider taxable earned income.
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10 Cited Research Articles
- U.S. Internal Revenue Service. (2020, July 31). What is Earned Income? Retrieved from https://www.irs.gov/credits-deductions/individuals/earned-income-tax-credit/earned-income
- Ortiz, H. and Scheithe, E. (2020, June 30). Considering an Early Retirement Withdrawal? CARES Act Rules and What You Should Know. Retrieved from https://www.consumerfinance.gov/about-us/blog/cares-act-early-retirement-withdrawal/
- U.S. Internal Revenue Service. (2020, January 28). Traditional and Roth IRAs. Retrieved from https://www.irs.gov/retirement-plans/traditional-and-roth-iras
- U.S. Internal Revenue Service. (2020, January 15). Traditional IRAs. Retrieved from https://www.irs.gov/retirement-plans/traditional-iras
- U.S. Internal Revenue Service. (2020, January 10). Roth IRAs. Retrieved from https://www.irs.gov/retirement-plans/roth-iras
- U.S. Internal Revenue Service. (2020, January 9). Individual Retirement Arrangements (IRAs). Retrieved from https://www.irs.gov/retirement-plans/individual-retirement-arrangements-iras
- U.S. Internal Revenue Service. (2019, December 20). IRA Deduction Limits. Retrieved from https://www.irs.gov/retirement-plans/ira-deduction-limits
- U.S. Securities and Exchange Commission. (n.d.). Individual Retirement Accounts. Retrieved from https://www.investor.gov/additional-resources/retirement-toolkit/self-directed-plans-individual-retirement-accounts-iras
- Cornell Law School. (n.d.). 26 U.S. Code Section 408 - Individual Retirement Accounts. Retrieved from https://www.law.cornell.edu/uscode/text/26/408
- CNN Money. (n.d.). What Is an IRA? Retrieved from https://money.cnn.com/retirement/guide/IRA_Basics.moneymag/index.htm