What is an IRA?
An IRA is an individual retirement account and is a popular tool used to save for retirement.
IRA accounts are widely used because they are tax-advantaged relative to a standard brokerage account or savings account.
Individual retirement accounts come in several types and can be invested in a wide variety of investment options.
Types of IRAs
Almost anyone can open and contribute to an individual retirement account as long as they are under the age of 70½ and earned income through some kind of employment in the past year.
If they did not earn income through a job, they cannot contribute to an IRA, even if they received income from other sources such as investments or an inheritance.
There are two primary types of individual retirement accounts to choose from: the traditional IRA and the Roth IRA.
The SEP and SIMPLE versions are for self-employed individuals and small businesses and function much like a traditional IRA with a few small variations.
Both the traditional and the Roth individual retirement accounts allow the participant to benefit from tax advantages, but the tax advantages are structured differently, and the two account types have slightly different rules.
In a traditional IRA, participants are allowed to contribute pre-tax income to their account. Pre-tax income is income before federal income taxes and most state taxes have been taken from a paycheck.
Once money has been contributed, it can be invested without incurring capital gains taxes until money is withdrawn. Taxes on income and capital gains are owed when money is withdrawn from the account.
In other words, the traditional individual retirement account owner benefits from two distinct tax advantages that can really add up over time; however, there are some rules and limitations.
For one, funds withdrawn before the age of 59½ will carry a 10 percent tax penalty in addition to the other taxes owed. There is also an annual contribution limit, which varies depending on annual income and tax filing status.
Finally, once a traditional IRA owner turns 70½, there are minimum withdrawal requirements dictated by the IRS.
In a Roth IRA, participants can only contribute post-tax income to their account.
The post-tax income contributed to the Roth can be withdrawn at any time without penalty. However, investment gains on the contributed capital cannot be withdrawn until the age of 59½ without incurring a 10 percent tax penalty.
After the age of 59½, a Roth account owner can distribute funds without paying any taxes. Roth accounts are also subject to an annual contribution limit that varies depending on annual income and tax filing status.
The above table compares traditional IRAs with Roth IRAs.
There are small technical differences, but the big difference is how the tax advantages are structured. A traditional account owner gets an up-front tax benefit by deferring taxes on contributed income and capital gains until retirement.
A Roth account holder contributes post-tax money initially, but does not pay any taxes on gains later.
If you expect your tax rate to go down during your retirement years, a traditional IRA would make more sense. If you expect your tax rate to go up during your retirement years, a Roth account would make more sense.
IRAs vs 401(k) Accounts
IRAs share similarities with 401(k) accounts, but there are some key differences.
Both individual retirement accounts and 401(k) accounts are tax-advantaged savings accounts that can be used to invest in financial markets. 401(k) accounts operate like traditional IRAs in that they are funded with pre-tax income and accrue tax liabilities upon withdrawals, with a similar penalty for early withdrawal before the age of 59½.
Anyone under the age of 70½ with earned income can contribute to an IRA, but to open a 401(k) account, your employer must sponsor a 401(k) plan.
IRAs have more investment options; 401(k) accounts can only invest in a menu of investment options selected by the 401(k) plan sponsor.
If your employer offers 401(k) accounts, you can invest in both that and an IRA if you meet all the eligibility requirements. If you leave an employer, you can roll over a preexisting 401(k) account into a traditional IRA.