What Is an IRA and How Does It Work?
Individual retirement accounts are special financial accounts designed to help people save for retirement. If you’re looking for a way to build your nest egg, you might be wondering whether opening an IRA is the right option for you. Read on to learn about common types of IRAs and the advantages they offer.
What Is an IRA?
The history of the IRA goes back to the 1960s and early ’70s. According to Forbes, companies like Studebaker were struggling to pay pensions to thousands of workers. In 1974, the crisis led Congress to enact the Employee Retirement Income Security Act. This law created new regulations for pensions and retirement plans like the IRA. A new era of how people funded retirement was soon underway. Saving for retirement became the responsibility of individuals, not employers. Few companies continued to offer pensions.
IRAs are tax-advantaged retirement savings accounts. There are several types of accounts, each with its own eligibility rules and contribution limits. Some contributions are tax deductible. Some withdrawals may be tax-free. IRAs are unique compared with traditional savings vehicles because they have market exposure. You can own stocks, mutual funds and other securities in an IRA, entailing that the account value can compound quickly compared to savings accounts, CDs and money market accounts.
Benefits of IRAs
The obvious benefit of IRAs is that they allow people to save for retirement. Social Security benefits alone are typically not enough to provide people with an income during retirement. Without pensions, it’s up to individuals to save for their retirement themselves.
IRAs provide better returns than traditional savings accounts. For example, Bank of America is currently advertising a 0.01% interest rate for its standard savings account. This rate doesn’t come anywhere close to keeping up with inflation. Meanwhile, IRAs take advantage of the stock market and other securities, which on average generate much higher returns.
IRAs are also tax-advantaged accounts. For traditional IRAs, contributions are usually tax deductible. You won’t have to pay taxes on any dollar you put into your IRA in a given year. You will, however, pay taxes on withdrawals. Roth IRAs, on the other hand, do not provide tax-deductible contributions. Instead, qualified withdrawals and gains are tax-free.
Pay Attention to the Rules
There are rules for how you can withdraw funds from IRAs. If you’re not careful, the IRS might charge you enormous fees and penalties. For example, if you withdraw funds before the age of 59 1/2, you might have to pay taxes and a 10% penalty. The IRS allows some exceptions.
Types of IRAs
There are several types of IRAs to choose from. Each of them has different characteristics and is suited for different situations. Here is an overview of some of the most common types.
Traditional IRAs are perhaps the most common type. In 2020 and 2021, total annual contributions were limited to $6,000. The IRS has a provision that allows you to contribute up to $7,000 if you’re age 50 or older. Contributions may be fully or partially tax deductible, depending on your filing status and income.
These limits do not apply to rollovers, which is when you withdraw funds from one IRA and put them into another. Generally, people perform rollovers when they want to change institutions or combine separate accounts.
The balance in your IRA will continue to grow on a tax-deferred basis until you take a distribution, also known as a withdrawal. Withdrawals from traditional IRAs are then taxed as income according to your tax bracket.
Roth IRAs have the same contribution limits as traditional IRAs: up to $6,000 or $7,000 in 2020 and 2021. However, some restrictions limit contributions based on income and filing status. For example, if your filing status is married filing jointly and you have a modified adjusted gross income greater than $208,000, you cannot contribute anything to a Roth IRA.
The Roth IRA’s main advantage is that your balance generally grows tax-free and qualified withdrawals from the account are tax-free. This benefit can lead to significant long-term tax savings.
The Savings Incentive Match Plan for Employees IRA is a plan designed for small businesses with fewer than 100 employees. SIMPLE IRA plans are very similar to traditional IRAs and feature tax-deductible contributions. As the acronym suggests, they are simple to set up and operate.
There are some differences between the SIMPLE and traditional IRA. Employers must contribute to the SIMPLE IRA plan. Contributions from an employee can only come from their salary, limited to an annual total of $13,500 in 2020 and 2021.
The Simplified Employee Pension plan is a retirement plan for businesses of any size. SEP plans have low administrative costs and are very easy to set up. Employers are the only ones allowed to contribute to these plans, up to 25% of an employee’s salary. Contributions and withdrawals are treated like a traditional IRA.
How To Get Started
Many brokers allow you to open an IRA for as little as $0. Some brokers charge annual fees and commissions for your account, while others may offer certain promotions and bonuses. Do your research to find the best broker for you. Take a quick look at the best Roth IRA providers and best IRA providers so you can compare fees and promotional offers.
Rates are subject to change; unless otherwise noted, rates are updated periodically. All other data is accurate as of April 8, 2021.
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- IRS. 2021. "Traditional IRAs."
- IRS. 2020. "Amount of Roth IRA Contributions That You Can Make For 2021."
- IRS. 2020. "Retirement Topics - SIMPLE IRA Contribution Limits."
- IRS. 2021. "Choosing a Retirement Plan: SEP."