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An IRA, or individual retirement account, lets you set aside and invest money for retirement in a way that can help you avoid or minimize the taxes you pay on those funds.
How Does an IRA Work?
An IRA lets you set aside funds today for use in your retirement, up to an annual limit. IRAs can be set up at a variety of financial institutions, with funds placed in interest-bearing accounts, investment funds such as mutual funds or bond accounts, or a combination of all of these.
The most common type of IRA, the traditional IRA, lets you set aside money on a pre-tax basis—meaning you deduct your annual contribution to the fund from the taxable income you report on your federal income tax return. When you withdraw from the fund, the money you take out is treated as taxable income. The benefit of this approach lies in the likelihood that most individuals pay taxes at a higher rate during their peak earning years than they do during retirement, so deferring the taxes on IRA contributions ultimately means paying less income tax on those funds.
The money in your investment account is managed differently depending on how your account is set up:
- Professionally managed: A firm makes investment decisions on your behalf, taking into account the level of risk you're comfortable with, goals and other stipulations.
- Self-managed: You decide on your own investments, which affords you more control over your money but requires a fair degree of research and labor.
- Passive: You choose an investment and stick with it long term. Passive IRAs often are invested in market index funds that reliably grow over a long period of time, instead of potentially riskier short-term investments other plans might pursue.
All are designed with the intention that funds should be set aside and accumulate over the course of the owner's career and not cashed out at least until the individual reaches the age of 59½.
Is an IRA the Same as a 401(k)?
The savings and investment strategies and tax benefits of a traditional IRA are similar to those of 401(k) plans, but 401(k) plans are provided (and often partially funded) by employers as part of their employee benefit programs. An IRA, as its name implies, is set up and maintained by an individual. If you have both a 401(k) and an IRA, but you can't afford to fully fund both, you may want to consult a financial advisor or a rep for your company 401(k) plan to decide how to allocate savings between them. At the very least, it's advisable to make sure you earn your employer's full matching contribution to the 401(k) before placing funds in an IRA.
What Are the Types of IRAs?
There are several types of IRAs available, each with different filing procedures and tax advantages:
- Traditional IRA: The most common type of IRA, the traditional IRA lets you set aside funds on a pretax basis. You'll pay income on the proceeds (including any accumulated interest or investment value) when you withdraw from the fund, ideally in retirement. You'll pay a 10% tax penalty on any funds you withdraw before you reach the age of 59½, and you must start withdrawing from the fund (and paying taxes on the proceeds) at age 72.
- Roth IRA: With a Roth IRA, contributions are made using post-tax dollars—you cannot deduct contributions on your federal income tax return. But the money in the fund—including interest or capital gains—is not treated as income (or subject to income tax) when you withdraw them from the fund. As with a traditional IRA, there are penalties for withdrawal before age 70½, but in contrast to a traditional IRA, there is no age at which withdrawals from a Roth IRA are mandatory. You can even bequeath the full contents of a Roth IRA to your heirs.
- Rollover IRA. A rollover IRA is a special-purpose traditional IRA you can use to transfer the contents of an employer-sponsored 401(k) retirement savings plan when you switch employers. Many employers will let ex-employees stay enrolled in their 401(k) programs, but they typically charge ex-employees fund management fees that current employees don't have to pay. Moving 401(k) funds into a rollover IRA can reduce fees and give you greater control over how the funds are invested.
- Spousal IRA. In families with a nonworking spouse, it's possible to fund an IRA with the working spouse's income and use the same tax advantages available to the working spouse's own IRA. Spousal IRAs can be traditional or Roth accounts.
- Other specialty IRAs. Other types of IRAs are available to self-employed persons (SEP IRA), to small business owners offering IRA contributions to employees (SIMPLE IRA), and to individuals with sophisticated tax needs and strategies (so-called backdoor Roth IRAs). If these are applicable to you, consult your financial advisor for advice on how to set them up.
You can maintain one or all of these account types, as long as you obey the laws governing the maximum contributions you can make to them each year. For 2020, you're permitted to contribute $6,000 annually to all of your IRA accounts combined if you're under the age of 50; if you're 50 or older, you can contribute a total of $7,000 annually. Which type of IRA(s) are best for you depends upon your tax circumstances, retirement goals and the nature of your other assets and investments. Consulting a tax professional or financial advisor for guidance might be a good idea if you're planning to establish one or more IRA funds.
How to Open an IRA
Setting up an IRA is pretty straightforward. Accounts are available from many financial institutions as well as investment houses and mutual fund providers. Compare plans to understand their fees and the degree to which investments are managed. Some funds are maintained by investment professionals, while others are devoted to one or more types of savings account or investment fund unless you change them and still others are managed using sophisticated trading algorithms.
It's important that you understand your fund's investment strategies and risk levels, and that you understand and accept the fees associated with fund management. Ask plenty of questions and rule out any funds that don't provide satisfactory answers, or that don't seem to have time to get back to you.
After making an initial deposit to open the fund, it should be easy to arrange ongoing direct deposits from your paycheck or bank account.
As with any investment program, the key to success with an IRA is to begin funding it as early in your career as possible, and to make steady contributions over the long haul—ideally reaching a point where you can max out your contribution, paying in the maximum sum allowed by law every year.
An IRA can be an important element of any retirement planning strategy, and the sooner you get one (or more) working for you, the greater will be the benefit when you're ready to retire.