What is an IRA account? Learn how it works and whether it’s right for you.

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In a Nutshell

If you’re planning ahead for your retirement, opening an IRA may be worth considering. Along with a 401(k) and Social Security, an individual retirement arrangement might be a solid foundation for your nest egg. But before you start investing, you’ll want to know about the different types of IRAs and how they work so you can better strategize for your financial goals.
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Have you ever wondered, “What is an IRA account?” An individual retirement arrangement account is one of several options you may have as you’re considering how to grow your money for retirement.

Unlike employer-driven 401(k) retirement plans, IRAs are often designed for people who want to save even more money and have more control over their retirement funds.

Let’s take a closer look at what exactly an IRA is, how it works, what the rules are and how to find the right one for your retirement account.

What is an IRA account?

Along with your employer-sponsored 401(k), an individual retirement account is one of the most common ways to save money for retirement. The types of IRAs that you’ll hear about the most are traditional IRAs and Roth IRAs.

If you’re self employed or own a small business, you might also have the opportunity to contribute to a simplified employee pension (SEP) IRA or SIMPLE IRA. These types of IRAs might be worth looking into if they apply to your situation.

Why do I need an IRA?

IRAs may be worth considering for the following two reasons: 

  1. They might help you reduce your taxable income while helping you save money for retirement.
  2. IRAs may offer an additional source of income so you don’t have to solely rely on living off of Social Security benefits in your golden years.

With IRAs, you typically have the opportunity to choose your own investments and watch them grow until you retire. Depending on the IRA providers you may be looking at, you might have the option to select from various stocks, mutual funds and ETFs.

And if you have an employer-sponsored 401(k), when you leave your job, you have an option to roll over your account into an IRA. As with all investments, you’re never guaranteed a return, and we strongly advise that you review any and all plan materials very carefully.

Pros of having an IRA

IRAs can be an important tool on your path to retirement. 

  • Retirement savings — With an IRA, you can save money for retirement to supplement any Social Security benefits you might collect.
  • Taxes — You’ll enjoy tax advantages compared to a regular brokerage account.
  • Flexibility — You might have greater flexibility to pick your own investments than you would with a 401(k).

Cons of having an IRA

Before you open an IRA, it’s important to know what you’re getting into. Let’s take a look at some of the cons.

  • Limits — You’ll face strict contribution limits, so you might not be able to save as much as you want.
  • Early-withdrawal penalties — With few exceptions, you might pay a penalty to take out your money before retirement.
  • Required withdrawals — On the other hand, you could be forced to withdraw money from your traditional IRA sooner than you want.

What to know about IRAs

Depending on your situation and investment goals, IRAs may be worth considering as a holistic retirement savings plan.

But like most savings and investment vehicles, they come with their own set of rules and guidelines you should keep in mind — or risk facing some steep penalties.

Who can contribute to an IRA?

If you have a job, you’re likely able to contribute to a traditional IRA. While Roth IRAs have income limits for people who are in a higher tax bracket, generally, anyone who earns money can contribute to a traditional IRA.

What is the minimum amount I need to open an IRA?

The IRS doesn’t require a minimum amount of money to open an IRA, but your bank might.

It’s still worth saving for retirement, even if you can’t max out your IRA each year. Every penny helps when it comes to setting aside money for your future. So if your bank’s IRA minimum is too high, don’t give up. Instead, try looking for a bank that has no minimum.

What’s the most I can contribute to my IRA?

The IRS limits the amount of money you can contribute to your IRA. If you’re under 50 years old, your annual contribution limit is only $6,000 per year. But if you’re older, you can save a little more: up to $7,000 per year. In both cases, you can contribute no more than you make each year.

For some people, this might be more than they can afford, but others might be disappointed they can’t save more.

Are IRA contributions tax deductible?

Traditional IRAs allow for tax-deductible contributions. Depending on your situation, you might be allowed to deduct your traditional IRA contributions from your taxable income.

Roth IRAs, on the other hand, are not tax deductible.

Will my IRA distributions be taxed after I retire?

After you retire, traditional IRA distributions are taxed, but Roth IRA distributions are not.

An easy way to think about it is to remember that you only have to pay taxes once. So if you have a Roth IRA, you’ll get your taxes out of the way from the get-go. But if you have a traditional IRA and don’t pay taxes upfront, you’ll be charged on the back end.

When can I start taking money out of my IRA?

In most cases, you won’t be able to touch your money until age 59 ½. For both traditional and Roth IRAs, this is the age when you can begin taking distributions without paying a tax penalty. While there are a few exceptions to this rule, you should plan on investing your money for the long haul.

That means you can begin withdrawing money from your IRA several years before you qualify for Social Security or Medicare. But if you retire earlier than that, you might not be able to tap into your money right away without paying a penalty.

What if I need my money sooner?

Your IRA is intended to be a long-term investment.

So if you take your money out early, you might be subject to steep tax penalties. This is why we highly recommend that before you make any retirement plans, you have your emergency fund set up and fully funded.

But we understand that sometimes you need to access your cash, even if it’s your retirement savings. 

So you should know that money can be withdrawn from a Roth IRA at any time. However, particular tax rules apply.

Since contributions to your Roth IRA are after-tax, they won’t be taxed again when you take those funds out. These non-taxable contributions are treated as coming out of the Roth IRA before earnings, which may be subject to tax depending on whether the distribution is qualified. 

Earnings on a qualified distribution are not taxable. To be considered qualified, the distribution must be made at least five years after the owner’s first contribution to the Roth IRA and the withdrawal is made …

  • After the owner is 59 ½. 
  • For a qualified first-time home purchase (up to $10,000 lifetime limit)
  • After the owner is disabled
  • To a beneficiary after the owner’s death or disability

If a distribution is not qualified, any earnings in the Roth IRA are taxable. And if the owner is under 59 ½, an additional 10% income tax on earnings will apply. Exceptions include higher education expenses and a qualified first-time home purchase (up to $10,000 lifetime limit)

How long can I leave money in my IRA?

You can keep your IRA open until you run out of money. There’s no maximum age when you’re required to withdraw money from your Roth IRA. But if you have a traditional IRA you must begin taking required minimum distributions once you reach age 72.

Traditional IRA or Roth IRA: What’s the difference?

Many people choose to save money for retirement in an IRA instead of a regular investment account because an IRA offers certain tax advantages.

If you have a traditional IRA, your contributions might be tax deductible upfront, depending on your situation, but you’ll still pay taxes when you take money out of your account in retirement. And the IRS is only so patient: Because you won’t be taxed until you take money out of the account, the IRS requires you to begin taking distributions when you turn 72 years old.

On the other hand, if you have a Roth IRA, you’ll pay taxes initially. But because you’re contributing after-tax dollars, you won’t be required to pay taxes again in retirement. This allows both your contributions and earnings to grow tax-free, and you can keep your money in the account as long as you want.

Additionally, IRAs face certain income restrictions. If you make too much money, you won’t be able to contribute to a Roth IRA. And while you can still contribute to a traditional IRA, you won’t be able to take the initial tax deduction.

Alternatives to IRAs

If an IRA doesn’t align with your retirement goals, you may have other options. For example, you may consider investing your money in mutual funds, bonds, stocks, real estate, commodities and other investment vehicles.

Keep in mind that the riskier the investment, the higher the potential reward tends to be, but there’s no guarantee that you’ll earn any money from any investment — and you could lose it all. For more specific advice, you might also find it helpful to speak with a financial adviser. They could help you look at your current situation and your long-term savings goals to help develop a plan that is right for you.

Calculate your Social Security benefit

Use our Social Security calculator to find your estimated monthly Social Security benefit for when you retire.

About the author: Tim Devaney is a personal finance writer and credit card expert at Credit Karma. He’s a longtime journalist who prides himself on being a good storyteller who can explain complex information in an easily digestible wa… Read more.