What is an IRA?

An IRA (Individual Retirement Arrangement) is a tax-advantaged investment account intended to be used for the goal of retirement. You’ve likely heard the term or may even have your own IRA, but what makes these accounts unique? How is an IRA different from an employer-sponsored retirement account, like a 401k?

How does an IRA work?

IRAs are individual accounts opened most commonly through a bank or brokerage. Contributions to IRAs are generally made via online transfers directly from a bank account. Many institutions providing IRAs allow the account holder to set up recurring scheduled deposits, which can then be automatically invested on a regular basis. 

IRAs can also be funded with money from an employer-sponsored retirement plan, like a 401k, through a process known as a rollover.

Like other retirement accounts, the IRS has limits on the exact amount that can be contributed each tax year, who is eligible to contribute, and what portion (if any) of an individual’s contributions may be tax-deductible. Eligibility generally depends on income and employment and tax filing status.

When opening an IRA, there are generally two options to choose from. Each option has its own unique tax advantages, income limitations, and eligibility requirements.

Traditional IRA

Income earned within a traditional IRA from interest, dividends, or capital gains is not taxed as it would be in a bank account or regular taxable investment account. Since earnings are not taxed, that money is allowed to be reinvested, increasing its compounding power. Ideally, taxation on the account is then deferred until retirement– when money is actually withdrawn from the account. Contributions may also be tax deductible each year, depending on the account holder’s income and eligibility. 

Roth IRA

Like traditional IRAs, income earned within a Roth IRA is not taxed, assuming certain rules are followed. This allows the money to grow without taxation over time. A key difference between a traditional and Roth IRA is that when money is withdrawn from the account, the account holder will pay no taxes on any earnings or contributions, making those withdrawals and the growth of any money contributed, effectively tax-free.

Unlike a traditional IRA, Roth contributions are always made with after-tax dollars and are therefore, not tax-deductible. The benefit of using a Roth IRA vs. traditional IRA comes mainly from the fact that you are paying taxes today in order to not pay taxes at all when the money (and the growth of that money) is withdrawn. This advantage tends to benefit those contributing to a Roth in years where their income falls into a lower tax bracket than they believe they will be in when they retire. Paying taxes today at a rate that could be significantly lower than in several decades from now, could save the account holder a significant amount of money in the long-run. Plus, no need to worry about paying taxes when you’re ready to take the money out to live on for retirement income.

That said, both types of IRAs can have penalties for early withdrawal (before age 59.5) because they are designed to encourage long-term retirement savings. 

SEP and SIMPLE IRAs

Self-employed individuals and small businesses can also have special types of IRAs that share the features of a traditional IRA, but with additional benefits, like much higher contribution limits.

Get a free analysis of your 401k or IRA with Blooom

Now that you know what an IRA is and how it works, it’s best to consult with a tax professional in order to determine which specific type of IRA (or combination of IRAs) might make the most sense for you and your financial situation. Tax rules can change quickly and there are many factors to consider when it comes to the tax implications of investing in tax-advantaged accounts, like IRAs. Checkout blooom for your free, personalized analysis!

 

The information is provided for discussion purposes only and should not be considered as advice for your investments. Blooom does not provide tax advice. Consult a tax expert for tax-specific questions.

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