What is an IRA and How Does it Work? : Financial Stress

An Individual Retirement Account (IRA) is a type of vehicle for saving for retirement. This blog post answers the question of what an IRA is, so that you can determine if it’s a good solution for you.

What is an IRA?

Individual retirement accounts are referred to as IRAs. An individual retirement account is pretty much like a cookie jar. It is a way to save money for your retirement years, which may seem like a long time away, but the sooner you put money towards it—and the more you add—the better prepared you will be in retirement.

Once funded, your IRA can make investments in any combination of stocks, bonds, mutual funds and certificates of deposit and various other investments approved by your bank.

What Are the Advantages of an IRA?

The biggest advantage is they are a tax-advantaged investment vehicles which you use to put money aside for retirement. They provide a variety of advantages, such as tax-free growth and the option to withdraw your money without penalty once certain criteria are met

Both Traditional and Roth IRAs are the two most common individual retirement accounts. The differences of each are:

Traditional IRA

A traditional IRA is a savings account into which you can put money before taxes and then withdraw it tax-free after you reach the age of 59 1/2. Due to the fact that this is pre-tax income, you may be able to reduce your overall tax payment for the year if the amount you contributed reduces your adjusted income into a lower tax bracket.

Roth IRA

A Roth IRA works similarly to a Traditional IRA, with the exception that contributions are made with after-tax dollars, which means they cannot be deducted from your taxable income. Qualified distributions (those made at least five years after the first deposit and at least 59 1/2) are tax-free when withdrawn.

Additional benefits of an IRA:

Accessibility: A Traditional and Roth IRA are both simple to open and contribute to. There is no minimum age to open an account but you must have earned taxable income to contribute. Your contribution limits may be adjusted depending on your tax filing status and the amount of your modified adjusted gross income. You can choose to manage your money on your own or hire a professional like a financial planner to assist you with your approach.

Traditional IRA Tax Break: Tax-deferred growth is a fundamental benefit of traditional IRAs. Contributions to a Traditional IRA are made with pre-tax dollars which will reduce your taxable income, you can make deductible contributions of up to $6,000 (or $7,000 if you’re 50 or older).

Defer Your Roth IRA Tax Break: A Roth IRA may be the best option for you if flexibility is important to you. Your earnings when withdrawing after age 59 1/2 are not taxed since you contributed after-tax dollars. Roth IRAs make cashing out easier in retirement because withdrawals are tax-free. Keep in mind, though, that your combined contribution to both IRAs is capped at $6,000 each year. Roth IRAs are also subject to income limits and phase-outs.

Your IRA is …Yours: Only 68 percent of workers in the United States have access to a company-sponsored retirement plan. Thousands of investment options are available in qualified IRAs. With an IRA, you can tailor your portfolio to meet your specific financial goals.

Other Types of IRAs

As mentioned above, Traditional and Roth IRAs are the most popular IRAs for most people. But there are alternatives to be aware of:

SEP IRA

A Simplified Employee Pension (SEP) is a type of IRA that can be set up by an employer or a self-employed person. According to the US Federal Reserve, SEP IRA contribution limitations are annual and generally greater than ordinary IRAs and 401(k)s.

SIMPLE IRA

This is a retirement savings plan that can be used by most small businesses with less than 100 employees. SIMPLE stands for Savings Incentive Match Plan for Employees. Employers can make a non-elective contribution of 2% of the employee’s pay or a dollar-for-dollar matching contribution of up to 3% of the employee’s salary.

Self-Directed IRA

Investors seeking higher returns and greater diversification in their retirement accounts are increasingly turning to Self-Directed IRAs (SDIRAs). SDIRAs allow investors to invest in assets other than stocks, bonds, ETFs, and mutual funds that are available in traditional and Roth IRAs. SDIRA investors might potentially generate substantially higher returns by investing in assets such as real estate, closely held enterprises, foreign currencies, private loans, and commodities. But keep in mind the potential for greater returns also comes with greater risk and the use of an SDIRA must be chosen carefully.

When Can I Withdraw From an IRA?

To make a withdraw from an IRA without penalty, you must be at least 59 1/2 years old, regardless of which IRA you pick. Otherwise, additional taxes may be imposed as determined by the IRA type you select and IRS guidelines.

To withdraw cash from an IRA without penalty, you must be at least 59 12 years old, regardless of which IRA you pick.

How Is a 401(k) Plan Different from an Individual Retirement Account (IRA)?

A 401(k) plan is a type of employer-sponsored retirement plan. An IRA is a type of investment account that an individual creates.

The key distinction between 401(k)s and IRAs is that a 401(k) allows for higher contribution limits and allows your employer to contribute. Both have stiff penalties for early withdrawals; however, your 401(k) may have a provision for a loan. (Check with your employer if this option is available). 401(k)s typically have vetted investment options that are monitored by your employer and an IRA while there are a greater number of investment options you are required to do all of your own due diligence and planning unless you use the services of a financial planner. The great news is if you ever leave your employer and have an older 401(k) you can roll that money into your new employer’s plan or even an IRA.

Conclusion

An IRA is a great way to put money away for retirement. Furthermore, there are several different types of IRAs, each with its unique set of benefits. If you have any questions, let us know in the comments below.