What Is an IRA?
An individual retirement account (or IRA, sometimes referred to as individual retirement arrangement) is a savings plan that provides tax benefits for putting money aside to help cover expenses after retirement age. This differs from a 401(k) or other retirement plan that may be offered as a benefit through an employer in that it is created personally through a bank, insurance company, or other financial institution. The individual that sets up and makes contributions to the account is referred to as the owner. The institution holding the funds for the account is referred to as the custodian. IRAs allow for tax-exempt or tax-deferred contributions and earnings depending on the type of account and can help money grow for the future through proper management.
An IRA is not a standard interest-bearing savings account. The arrangement works on investing deposited funds into diversified stocks, bonds, and other options which will hopefully yield a positive return and allow money to grow beyond the contributions. There are a few types of individual retirement accounts that usually fall into three main categories.
Types of IRAs
Traditional IRA: This individual retirement account can be opened by anyone who has taxable compensation and is younger than 70 1/2 years old. Contributions may be tax deductible up to a certain point depending on income and are usually made with pre-tax dollars or may be deducted from your taxes when filing the next year. All earnings and transactions within the IRA are not taxed at the time, allowing investment returns to be earned tax-deferred. Distributions from the account can be taken at any time and are then taxed at the individual's current tax rate (which, for many retired Americans, is lower than their tax bracket while working). If you withdraw from a Traditional IRA under the age of 59 1/2, there may be an additional 10% tax penalty. In a Traditional IRA, the owner must begin taking distributions and cannot make any further contributions once they have reached 70 1/2 years of age.
Roth IRA: There are different limitations on a Roth IRA than a Traditional IRA. To contribute to a Roth IRA, the individual must meet IRS income requirements based on the tax year. Contributions can occur at any age and are not tax deductible; they are made with after-tax income. There is no required distribution from a Roth IRA, and withdrawals or distributions may qualify for an exception that will make them tax deductible. Roth IRAs have the same potential 10% tax penalty on early withdrawals.
Rollover IRA: When a Traditional IRA is being used to absorb assets from other retirement accounts to retain tax benefits, it is sometimes referred to as a Rollover IRA. Rollover IRAs are often used to avoid tax penalties that come with taking a cash distribution from a plan like a 401(k) due to change in employment.
IRAs are funded by contributions from the owner of the account, either pre-tax or after tax, depending on the type of IRA listed above. Contributions have specific IRS limitations across all forms of IRAs. An individual may have multiple IRAs, yet there is a single limitation that covers all accounts. As of 2015 and 2016 tax codes, total contributions to all Traditional and Roth IRAs cannot exceed $5,500 in a year (the limit is raised to $6,500 for those age 50 or older). Rollover contributions do not count against this limit.
For example: If a 36-year-old person has both a Traditional IRA and a Roth IRA from two separate financial institutions and has already contributed $3,000 in the year to their Traditional IRA, they may only contribute $2,500 more within the year between either IRA. In the event of a change in employment, they would still be able to rollover the value of their 401(k) into the current Traditional IRA or a new IRA without counting against that amount.
Once money is contributed into an IRA, the owner may choose from numerous investments into which the funds can be diversified. Some custodians may offer specific management plans that choose investments for the owner over time, while many owners also choose their own investments based on the current value of the IRA. In some cases the custodian may have institutional limitations on the sorts of investments allowed, while other investments are limited by federal regulations.
Different investments have different potentials for growth of money. Certain stocks have a chance for much greater growth but also carry higher risk, whereas investing in bonds usually displays a slower growth but is much less affected by shifts in the stock market.
Because IRAs are based on investments into traded securities, bonds, and other fluctuating entities, there is always an element of risk as with any investing. Volatility in the stock market and general downturns in the economy can cause investments to bear no growth or, in worst cases, to diminish the value of the IRA significantly. These risks can be mitigated by choosing both your financial institution and your investments wisely based on research and in some cases by deciding to forego some growth to invest in more stable options.
As mentioned above, the main benefit of setting up and contributing to an IRA is in saving on taxes while funding retirement. Savvy owners may lower their tax bracket by properly using pre-tax investments and avoiding early withdrawals to gain the most benefit. Properly invested funds can grow and allow the owner to lose much less money to taxes in the long run.
When it's time to choose an IRA or other retirement plan, be sure to take into account your current financial situation and your goals for your retirement years. Talking to the right financial planner may help in navigating complexities to determine which plans are right for you. The task can seem daunting at first, but proper planning and deeper research can give you the most for the money you've worked hard for throughout your life once it's finally time to retire.