Individual Retirement Account (IRA): What It Is & Types

Individual Retirement Accounts, more commonly known as IRAs, are a fundamental part of retirement planning for many Americans. Despite being different from annuities altogether, they carry certain similarities in both motivations and workings to the widely popular retirement tool. By offering a tax-advantaged means to create a retirement savings account, they can provide you with both peace of mind and financial security in your golden years. Join us as we cover everything you need to know about IRAs, from their basics to their subtleties.

What is an IRA Account?

Essentially, an Individual Retirement Account (IRA) is a tax-advantaged savings account put in place to help investors save funds for retirement. IRAs allow you to access and invest in a variety of assets, be it stocks, bonds, or even mutual funds, all while diminishing tax liabilities to further heighten your savings over time.

How Does an IRA Work?

If you were to contribute to an IRA, you are provided with a wide range of financial tools to invest in. This enables a certain degree of customizability for your overall investment, as it’s up to you to decide where your capital goes by evaluating factors such as risk tolerance or retirement needs. The hopeful fruition of your investments within the IRA is tax-deferred, meaning taxation isn’t applied to any profits made until the funds are finally withdrawn during retirement. Depending on the type of IRA you selected, you may receive a tax deduction for your contributions or even collect entirely tax-free withdrawals.

What types of IRAs are available?

There are two major types of IRAs: traditional IRAs and Roth IRAs. Both allow you to make annual contributions of up to $5,000 in 2010 and 2011. Generally, you must have at least as much taxable compensation as the amount of your IRA contribution. But if you are married filing jointly, your spouse can also contribute to an IRA, even if he or she does not have taxable compensation. The law also allows taxpayers age 50 and older to make additional “catch-up” contributions. These folks can put up to $6,000 in their IRAs in 2010 and 2011.

Both traditional and Roth IRAs feature tax-sheltered growth of earnings. And both give you a wide range of investment choices. However, there are important differences between these two types of IRAs. You must understand these differences before you can choose the type of IRA that’s best for you.

Roth vs. Traditional IRA: What’s the Difference?

• Traditional IRA: Contributions here may be tax-deductible, and earnings grow tax-deferred within the IRA. However, taxes are applied upon withdrawals in retirement.

• Roth IRA: With this type of IRA, the initial contributions are made with already taxed dollars, but this enables withdrawals during retirement to be completely free of taxation. Additionally, this would include both the principal invested and the earnings made during accumulation.

In conclusion, the final choice between a traditional and a Roth IRA will be contingent on your current tax situation and financial goals. Whereas a traditional IRA offers the advantage of tax-deductible contributions and tax-deferred growth during accumulation, a Roth IRA provides tax-free withdrawals in retirement, including both the returns of principal and any potential profits made. When deciding between the two, also ask yourself: am I looking for a tax break right now, or do I want to guarantee zero tax obligations when I retire? Consider the tax bracket you expect to be in when retiring as well; the higher your anticipated tax bracket, the more you may profit from a Roth IRA.

Traditional IRAs

Practically anyone can open and contribute to a traditional IRA. The only requirements are that you must have taxable compensation and be under age 70½. You can contribute the maximum allowed each year as long as your taxable compensation for the year is at least that amount. If your taxable compensation for the year is below the maximum contribution allowed, you can contribute only up to the amount you earned.

Your contributions to a traditional IRA may be tax deductible on your federal income tax return. This is important because tax-deductible (pretax) contributions lower your taxable income for the year, saving you money in taxes. If neither you nor your spouse is covered by a 401(k) or other employer-sponsored plan, you can generally deduct the full amount of your annual contribution. If one of you is covered by such a plan, your ability to deduct your contributions depends on your annual income (modified adjusted gross income, or MAGI) and your income tax filing status. You may qualify for a full deduction, a partial deduction, or no deduction at all.

What happens when you start taking money from your traditional IRA? Any portion of a distribution that represents deductible contributions is subject to income tax because those contributions were not taxed when you made them. Any portion that represents investment earnings is also subject to income tax because those earnings were not previously taxed either. Only the portion that represents nondeductible, after-tax contributions (if any) is not subject to income tax. In addition to income tax, you may have to pay a 10½ early withdrawal penalty if you’re under age 59½, unless you meet one of the exceptions.

If you wish to defer taxes, you can leave your funds in the traditional IRA, but only until April 1 of the year following the year you reach age 70½. That’s when you have to take your first required minimum distribution from the IRA. After that, you must take a distribution by the end of every calendar year until your funds are exhausted or you die. The annual distribution amounts are based on a standard life expectancy table. You can always withdraw more than you’re required to in any year. However, if you withdraw less, you’ll be hit with a 50% penalty on the difference between the required minimum and the amount you actually withdrew.

Roth IRAs

Not everyone can set up a Roth IRA. Even if you can, you may not qualify to take full advantage of it. The first requirement is that you must have taxable compensation. If your taxable compensation is at least $5,000 in 2011 (and 2010), you may be able to contribute the full amount. But it gets more complicated. Your ability to contribute to a Roth IRA in any year depends on your MAGI and your income tax filing status. Your allowable contribution may be less than the maximum possible, or nothing at all.

Your contributions to a Roth IRA are not tax deductible. You can invest only after-tax dollars in a Roth IRA. The good news is that, if you meet certain conditions, your withdrawals from a Roth IRA will be completely free from federal income tax, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must meet a five-year holding period requirement. In addition, one of the following must apply:

• You have reached age 59½ by the time of the withdrawal

• The withdrawal is made because of disability

• The withdrawal is made to pay first-time homebuyer expenses ($10,000 lifetime limit from all IRAs)

• The withdrawal is made by your beneficiary or estate after your death

Qualified distributions will also avoid the 10% early withdrawal penalty. This ability to withdraw your funds with no taxes or penalty is a key strength of the Roth IRA. And remember, even nonqualified distributions will be taxed (and possibly penalized) only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions that you have made.

Another advantage of the Roth IRA is that there are no required distributions after age 70½ or at any time during your life. You can put off taking distributions until you really need the income. Or, you can leave the entire balance to your beneficiary without ever taking a single distribution. Also, as long as you have taxable compensation and qualify, you can keep contributing to a Roth IRA after age 70½.

IRA Contribution Limits in 2024

In 2024, the maximum amount you can contribute to an IRA is 6,500$. For potential investors aged 50 or over, an additional catch-up contribution of 1,000$ is permitted, bringing the total contribution limit to 7,500$.

Why Invest in an IRA?

Like many of the other retirement investment options available, IRAs come with benefits that may set them apart for certain retirees. Let’s take a look at the key advantages of investing in an IRA:

• Tax Advantages: With an IRA, you may obtain certain tax deductions, as well as a guarantee of tax-deferred growth during accumulation. Depending on the type of IRA you select, fully tax-free withdrawals are also a possibility.

• Compounding Interest: With the help of their diverse investment options available, IRA investments can grow exponentially over time. This means that the sooner you start your IRA contributions, the more time they will have to compound, potentially leading to substantial growth by the time you reach retirement age.

• Investment Option Variety: Through an IRA, you can invest in a broad scope of assets, allowing you to spread out the risks associated. IRAs allow you to hold a mix of stocks, bonds, mutual funds, and other financial channels, enhancing the potential for returns and greatly lessening the prospect of fiscal losses.

• Retirement Savings: Being one of the most popular investment tools for retirement, IRAs can play a vital role in preparing for your post-employment future. If you consistently contribute portions of your salary to an IRA, you could amass a significant sum by the time you’re retired and ensure comfort in your golden years.

Choose the right IRA for you

Assuming you qualify to use both, which type of IRA is best for you? Sometimes the choice is easy. The Roth IRA will probably be a more effective tool if you don’t qualify for tax-deductible contributions to a traditional IRA. However, if you can deduct your traditional IRA contributions, the choice is more difficult. Most professionals believe that a Roth IRA will still give you more bang for your dollars in the long run, but it depends on your personal goals and circumstances. The Roth IRA may very well make more sense if you want to minimize taxes during retirement and preserve assets for your beneficiaries. But a traditional deductible IRA may be a better tool if you want to lower your yearly tax bill while you’re still working (and probably in a higher tax bracket than you’ll be in after you retire). A financial professional or tax advisor can help you pick the right type of IRA for you.

Note: You can have both a traditional IRA and a Roth IRA, but your total annual contribution to all of the IRAs that you own cannot be more than $5,000 ($6,000 if you’re age 50 or older).