Investing for Beginners: What is an Individual Retirement Account?

May 27, 2021

An Individual Retirement Account (IRA) is a type of investment account with tax benefits that can help individuals save for their retirement. These tax benefits depend on the type of IRA you choose: Roth or Traditional.

An IRA should not be confused with a 401(k), which is a type of employer plan. According to the Pew Charitable Trusts, 35% of private-sector workers don’t even have access to an employer-based plan. That’s why it’s a good option to invest money into an IRA account as a long-term savings plan for retirement.

Traditional IRA

With a traditional IRA, you make investments with money that you may be able to deduct on your tax return. Any earnings can potentially grow tax-deferred until you withdraw them in retirement. Your investments can reduce your tax bill in the year you contribute until you withdraw the money in retirement. For example, if you contribute $6,000.00 to an IRA account, your taxable income will be reduced by the amount of the contribution. However, when you withdraw that money in retirement, the withdrawals are taxed at their ordinary income tax rate. In most cases, contributions to this type of account are limited to $6,000.00. If you are 50 or older, the contribution may come to $7,000.00 per year.

Roth IRA

On the other hand, with a Roth IRA you invest money after taxes and then take out your earnings tax-free in retirement. That means the contributions are not tax-deductible. But your investments grow tax-free and you can withdraw your money when you retire without being taxed.

Roth IRA also allows you to save $6,000 per year or $7,000 if you’re 50 or older. This applies even if you are contributing to a 401K or other workplace savings plan.

Types of investments will vary

The right investment for you will depend on several factors. These include your goals and your ability to take risks with your savings. Typically, you can use almost any type of investment inside of an IRA, such as cash, certificates of deposits (CDs), mutual funds or ETFs, individual stocks and bonds, annuities and more.

A self-direct IRA allows investors to make all of the investment decisions for their account. It also affords access to a broader range of investments, like real estate, private placements and tax liens.

It’s always a good idea to diversify your assets among stocks, bonds and cash. Stocks can provide long-term growth potential but cashcan offer some protection against market setbacks.

People far from retirement would prefer the stock market, as individuals with ten or more years until retirement can afford to take on more risk.

The right allocation for you will depend on how long your money will be invested and how much variation you’re willing to accept in the value of your portfolio.

Anyone can contribute to an IRA account

Regardless of income, anyone can contribute to a traditional IRA account. But the deduction from your taxes may be limited by your income. If you or your spouse has access to a retirement plan at work and you’re under 70 ½, you can contribute.

Self-employed individuals or small business owners can set up SIMPLE and/or SEP IRAs. To set up a SIMPLE IRA, an employer must have less than 100 employees earning more than $5,000 each. In addition, the employer can’t have any other retirement plan besides the SIMPLE IRA. 

SEP IRAs are designed for independent or self-employed individuals like freelancers, contractors and small business owners. Contributions here are limited to 25% of compensation or $56,000, whichever is less.

Restrictions to discourage early withdrawals

IRAs are designed to fund retirement. While you’re allowed to retire at any age, the Internal Revenue Service uses age 591/2 as the age at which you can avoid certain penalties on a withdrawal from IRAs. You can take distributions before then but you may face tax penalties for early withdrawal, unless you meet certain criteria or use advanced strategies. That penalty is usually 10% of the amount you withdraw, in addition to income tax. 

Roth IRAs are more flexible if you need to withdraw some of the money early. With a Roth IRA you can leave the money in for as long as you want, letting it grow as you get older. With a traditional IRA you must start withdrawing the money when you reach 70 ½.

When they reach that age, holders of traditional IRAs must begin taking RMDs – required minimum distributions. These which based on their account size and life expectancy. If they don’t, it may result in a tax penalty equal to 50% of the amount of the required distribution.

Be aware when making your plan

IRAs are a powerful resource in helping you reach your retirement goals, but it’s important to stay tuned and seek information to decide what the best option for you is. There are some basic characteristics you should know to make an informed decision.  

  • Traditional and Roth IRAs require employment income. Incomes from investments, social security benefits or child support don’t count as earned income.
  • Whether you choose a Traditional or a Roth IRA, the tax benefits allow your savings to grow or compound more quickly than in a taxable account.
  • The earlier you start contributing to an IRA, the more money you can potentially make. The longer your money is invested, the more you can earn from compound interest.
  • IRAs can be opened at most financial service providers, like banks and credit unions, brokerage firms, big mutual funds or discount brokerages.
  • Advisors say that you should try to contribute the maximum amount to your IRA each year to get the most out of your savings.
  • Be sure to monitor your investments and make adjustments as needed, especially as retirement nears and your goals change.

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