What Is an Individual Retirement Account (IRA)?

During the retirement planning process, you may have seen the term, “IRA.” This is an individual retirement account (IRA), which is a tax-advantaged account that holds assets for your retirement, either tax-free or tax-deferred. These are a great way to save and grow your money for your post-working years.

IRAs can be wildly useful tools for retirement; however, they’re not all created equal. They can take several forms, such as a Roth, rollover, or traditional one, all of which have unique benefits and rules. In this article, we’ll teach you how they work, what the different types are, and whether one is right for you. You’ll also learn how to set one up.

How IRAs Work

IRAs are tax-advantaged investment accounts you can use to save for your retirement. Each year, you can contribute funds up to a certain amount. Then, you’ll be able to purchase assets to grow your wealth substantially over time. Once you’re ready, you’ll be able to withdraw money either tax-deferred or tax-free, depending on which type you’re using.

As of 2024, you can contribute up to $7,000 of earned income annually to your traditional or Roth IRAs (or $8,000 if you’re over 50 years old). Beyond that, it’s up to you to grow your wealth via investing in assets, such as:

• Stocks
• Bonds
• Mutual funds
• Exchange-traded funds (ETFs)
• Real estate investment trusts (REITs)

As mentioned, IRAs are tax-advantaged accounts. This is their true appeal. With a traditional account, you’ll be taxed on withdrawals; but your contributions are deductible. However, with a Roth, you can pull your money out completely tax-free! This means all of your contributions and profits are yours to keep.

The only catch to an IRA is that you must wait until you’re 59.5 years old before you can make withdrawals without penalty. Taking money out early will typically incur a 10% fee. Also, for traditional and SEP accounts, withdrawals become a requirement at the age of 73.

Types of Accounts

There are several types of IRAs you can choose from to save for retirement. Each has its unique benefits, rules, and guidelines. For instance, while traditional and Roth accounts are both tax-advantaged accounts, only the latter allows you to take money out tax-free.

Below is a detailed breakdown of the various IRA forms:

Traditional IRA

Traditional IRAs are tax-deferred retirement accounts. Your contributions are typically deductible; however, withdrawals are taxed as ordinary income. Whether or not your contributions are deductible depends on your filing status. Here are other key characteristics of a traditional account:

• $7,000 contribution limit (or $8,000 if age 50 or above)
• Required distributions start at the age of 73.
• Anyone is eligible to open an account.
• Contributions must be earned income.

Roth IRA

With a Roth IRA, you can make contributions each year toward your retirement. Then, after you reach age 59.5, you’ll be able to withdraw your money completely tax-free. But, unlike a traditional account, contributions aren’t deductible. Other important features include:

• $7,000 contribution limit (or $8,000 if age 50 or above)
• No required distributions
• Anyone is eligible to open an account.
• Contributions must be earned income.

Simplified Employee Pension (SEP) IRAs

An option for business owners or self-employed people is the SEP IRA. This account functions like a traditional one, which you can set up for yourself or any employees. Like the other types, you’ll be able to withdraw funds without penalty at the age of 59.5. The following are other important characteristics of a SEP account:

• Any size business and age are eligible.
• Can only contribute 25% of your income – $66,000 maximum.
• Required distributions start at 73.

Savings Incentive Match Plan for Employees (SIMPLE) IRAs

A SIMPLE IRA is similar to a 401(k) but for smaller businesses (typically 100 or fewer employees). It allows both employers and their employees to contribute to their own retirement accounts. It’s advantageous for employers because it comes with much less administrative work than a typical retirement plan.

Contributions to a SIMPLE IRA are tax-deductible. However, you must pay ordinary federal income tax on distributions. Employers must also match contributions that are up to 3% of an employee’s compensation. If an employee doesn’t contribute, employers must still make a mandatory 2% compensation contribution.

Self-Directed IRAs

A self-directed IRA works just like a traditional or Roth; however, you have more agency in what you can invest in. Often, your retirement account will limit you to certain securities, such as public stocks, bonds, and mutual funds. But with this type, you may be able to invest in alternative options, like private equity, real estate, or cryptocurrency.

While having more options to invest in sounds great, keep in mind that all of the assets in your account must be held by a qualified trustee or custodian. Your IRA custodian ensures you’re investing per the Internal Revenue Service’s (IRS) rules. They can also decide to not handle certain investments for you, meaning you won’t be able to invest in them using your account.

Traditional vs. Roth IRAs

The two major types of IRAs you’ll come across are the traditional account and a Roth. Each can be integral for retirement planning purposes, but they both have significant differences relating to how you’re taxed. A traditional account allows you to deduct contributions, but you’ll be subject to federal income tax once you make withdrawals. Roths, on the other hand, allow you to grow your investments and take distributions tax-free.

Here’s a table to help you compare the two types of IRAs:

Traditional IRA	Roth IRA
Contributions of $7,000-$8,000 per year	Contributions of $7,000-$8,000 per year
Contributions are tax-deductible	Contributions aren’t tax-deductible
Required distributions start at the age of 73	No mandatory distributions
10% penalty for withdrawals before the age of 59.5	10% penalty for withdrawals before the age of 59.5
Withdrawals are tax-deferred	Withdrawals are tax-free

Pros and Cons

Setting up an IRA can be great for your retirement, especially because of the tax advantages. However, like many other financial tools, they don’t come without their downsides. Below is a breakdown of the pros and cons of opening up one of these retirement savings accounts:

Pros

• Tax advantages. Perhaps the biggest upside of an IRA is the ability to either defer taxes or withdraw money without owing a dime to the IRS (with a Roth). And, if you defer taxes, you may be in a lower tax bracket when you retire. This can potentially save you a ton of money in the future.
• Great way to save and grow money for your retirement. IRAs are a powerful tool for your retirement. They allow you to buy assets to grow your finances over time via return on investment (ROI) and compound interest.
• Investment options. Unlike a 401(k), you have a wider range of assets to invest in with an IRA, such as stocks, bonds, ETFs, and mutual funds.

Cons

• Low contribution limits. Unfortunately, you can only contribute $7,000 to $8,000 per year with an IRA. This means you may need to use other types of accounts at the same time to build a viable retirement plan.
• Withdrawal penalties. You’ll incur a penalty if you take money out before you reach 59.5 years of age. This is highly limiting if you need the funds right now. It’s best to consider that money untouchable until you reach the eligible age.
• Required distributions (for traditional and SEP IRAs). Some accounts require you to take distributions at the age of 73 or you’ll face a penalty. This can put you in a tough spot if you’d rather keep the money in for tax purposes.

Is an IRA Right for Me?

IRAs are highly useful vehicles to set you up for retirement. Whether they’re right for you depends on your current financial situation. For instance, you must be eligible to make contributions. And if you don’t consistently put money in, you won’t stand to gain as much in the end.

If you’re on the fence about setting up an IRA or are unsure about which type is best, you’d benefit by speaking with a financial advisor. As you chart out your retirement plan, they can help you figure out whether this type of savings account fits your goals. To find someone, you can use a free matching tool, which will connect you with up to three vetted advisors in your area.

How to Set an Account Up

Opening up an IRA is a relatively easy process, which only requires a few steps. Additionally, most financial institutions allow you to create an account with them. Here’s a step-by-step guide to help you get set up:

1. Determine the type of IRA you want to open (traditional, Roth, SEP, SIMPLE, etc.). Here, you’ll need to figure out which account type is best. Each comes with its own benefits and drawbacks. The info above should be able to help you gain a top-level understanding of each, then you should speak with your financial advisor to figure out which one fits your retirement plan.
2. Select a financial institution to work with. There are plenty of places to open up an IRA, such as banks, credit unions, brokerage firms, and the like. Keep an eye out for fees and hidden costs when you’re conducting your market research. You should also ensure you have ample investment options.
3. Open your new account. Now, it’s time to create your account with your financial institution of choice. All you should have to do is go to its website and enter in personal info such as your Social Security number and date of birth, as well as your employment details. Keep in mind that this process can depend on the company.
4. Fund the account. Finally, you’ll need to set up contributions. Typically, you can simply transfer funds from your personal bank account. It’s also important to figure out how often you want to send money, as well as how much each time.

Frequently Asked Questions

What’s the difference between a Roth and a traditional IRA?

The biggest difference between the two is how taxes work. For Roth IRAs, you can withdraw your money tax-free, including any profits you made. But for traditional accounts, you’ll need to pay ordinary income tax on distributions. However, you can also deduct contributions with the latter type.

Can I have an IRA and 401(k)?

Yes, as long as you’re eligible, you can have both types of accounts. You’ll also need to heed the contribution limits that each one sets.

What is a rollover?

This is when you take funds from one retirement savings account, such as a 401(k), and move it over to another, such as a Roth IRA. You’d do this if you no longer need the old account but want to repurpose the funds to avoid taxes or withdrawal penalties.

As an example, let’s say you had a 401(k) at your job, but you’ve decided to quit. It may be smart to roll your funds over into your IRA (if you have one) to preserve your money.

What is a distribution?

This is when you opt to withdraw funds from your account. Typically, you can begin taking money out when you’re 59.5 years old. Also keep in mind that some IRAs, such as traditional and SEP accounts, require you to take distributions at the age of 73 or else you’ll incur a penalty.