An Individual Retirement Account (IRA) is a tax-advantaged investment account opened to save for retirement. Depending on the type of account, it allows your money to grow on a tax-deferred or tax-free basis. You can open an IRA at banks or with a broker, and your contributions may be tax-deductible, or withdrawals may be tax-free.
Let’s look at how an IRA account works and the different products.
How does an IRA work?
When you open an IRA, you contribute your funds which will be invested in various assets such as CDs, ETFs, stocks, and bonds. You’re not limited to a menu of investments as you often are in a 401(k). This allows you to take complete control of how this account is invested.
While you can move the money around freely, you can’t take it out early. IRAs are designed for retirement, which means that withdrawals before you are 59 1/2, will incur both taxes and a penalty of 10 percent unless you’re using the money for excused purchases such as buying your first home or paying for higher education (and those exceptions come with caveats).
If you don’t have the knowledge or feel insecure managing the investments for your IRA, it’s wise to look at Robo-advisors or pick a target-date retirement fund. Both are low-cost ways to get broad-based diversification tailored to your time horizon and risk tolerance.
Pros and Cons of a Traditional IRA
As discussed, an IRA saves money for retirement that is not an employee-sponsored 401(k) plan. Many self-employed or working for small businesses may choose this form of retirement planning. IRAs also have their pros and cons that we will cover.
- Tax-deferred: The funds you are investing go into a tax-deferred retirement account and can be set up anytime.
- Easy and cheap start: Plan holders essentially set up their own IRAs, often with little or no help from any financial planner. This saves not only time but cost.
- More investing options: While IRA holders may not have employers who match their contribution, they frequently have more investment options than a 401(k), including stocks, bonds, mutual funds, and CDs.
- More flexible allocation: While tracking the performance of an IRA, holders who find an element of the account that is not performing as expected, can easily tweak the distribution.
- Roth IRA option: The Roth is a popular choice for converting a traditional IRA. The difference between the two is that contributions to a Roth are made with post-tax dollars. Roth IRAs grow tax-free and offer tax-free income withdrawals at age 59 1/2. The catch is that you have to pay taxes on the amount you convert as if it were ordinary income.
- Tax deductions: Contributions to a traditional IRA are claimed as a tax deduction, dependent upon the policyholder’s income tax bracket.
- Limited contribution maximum: An IRA will allow the account holder to deposit up to $5,000 if younger than 49 years old or $6,000 if 50 and older.
- Low contribution rate: IRAs have a low contribution rate. The contribution rate may not be enough for those beginning an IRA retirement plan later in life.
- Penalties for early withdrawal: There are penalties for early withdrawal, just like in a 401(k).
- Required withdrawals at age 70 1/2: Policyholders are required to begin withdrawing money by 70 1/2 years of age.
Types of IRAs
There are three fundamental types of IRAs:
- Traditional IRAs: With these savings accounts, you can contribute up to a certain annual amount specified by the federal government. The maximum you can contribute to a traditional IRA in 2022 is $6,000 if younger than 50 years old. Workers over age 50 can add an extra $1,000 each year as a “catch-up” contribution, bringing the maximum IRA contribution to $7000.
- Roth IRAs: The contribution limits are the same as with traditional IRAs, although there is no requirement that you take money out at age 70 1/2. Withdrawals (after age 59 1/2) and investments within the account are tax-free if held for five years. Based on income, there are monetary limits on contributing to Roth IRAs.
- SEP and SIMPLE IRAs: Two types of IRAs — SEP IRAs and SIMPLE IRAs are available to sole proprietors and small-business owners who have less than 100 employees. Eligibility and contribution limits vary, and owners can fund their employees’ retirement with this type of plan.
Required Minimum Distributions
A required minimum distribution is the minimum amount you must withdraw from the account each year.
Under most circumstances, you have to start taking withdrawals out of your IRAs or retirement plan accounts when you reach age 70½. Due to changes in the SECURE Act, if your 70th birthday is July 1, 2019, or later, you do not have to take withdrawals until you reach age 72.
IRA vs 401k?
There are critical differences between a 401k and an IRA, and understanding those differences will help you decide which product is best for your financial situation.
Taxes and Distributions
You can withdraw funds from a 401(k) plan and a traditional IRA at age 59½. For a Roth IRA, as long as you keep the account for five years, there are no penalties for early withdrawal, and you aren’t required to withdraw the funds at a specific age.
With a 401(k) plan, you are limited to the investment options your employer chooses.
In contrast, an IRA provides a tremendous amount of freedom and doesn’t limit you to the investment options your employer presents. You may use your IRA contributions to invest in a wide range of available funds.
Your employer must first offer you a 401k plan to have one. When your employer offers a 401k, you decide on the amount you want to be deducted from your paycheck to start saving right away.
Anyone may open a traditional or Roth IRA with income and savings to create the account. Some financial institutions expect a minimum deposit of $1,000 or more.
How to open an IRA
There are multiple steps in opening an IRA, and we have compiled a list to walk you through the process.
Step 1: Choose where to open your IRA.
The first step is to choose what type of institution you’ll open your IRA through. There are many options to choose from, including banks, brokerage firms, and Robo-advisors.
If you want a less direct role in handling your IRA, then a Robo-advisor may be a better choice. Robo advisors usually include low management fees, automatic portfolio balancing, and other perks. These accounts are managed easily using an online dashboard.
For investors that want to be directly involved and hands-on. Brokerages offer full-service management and may have a more comprehensive choice of investments. If you want the most economical option, consider looking for discount brokers with low or no account fees and various commission- and fee-free investment options.
Avoid basing your final decision on the broker with the lowest prices or commissions. An affordable solution is essential, but other factors should play a role, such as your knowledge of investing, the brokers investing minimums, and the service they are known for.
Step 2: Select your IRA account type
There are several IRA accounts to choose from, which we discussed above, but the accounts included are:
- Traditional IRA’s
- Roth IRAs
- SEP IRAs
Step 3: Open your IRA account
Opening an account can be done online yourself or through your brokerage. However, the process will vary.
You may need the following documentation and information:
- A copy of your government ID
- Personal information, such as your name, phone number, date of birth, and Social Security number
- Details on your beneficiaries
- Banking information so you can fund the account with an electronic transfer
Step 4: Make contributions to your IRA.
Once your IRA is established, you can begin making contributions. You do this via rollover, check, or electronic payment, or, in some cases, you may be able to link your bank account and directly transfer funds.
IRA contribution limits by age
|50 or older||$7,000|
Roth IRA contribution limits
|Filing Status||Modified Adjusted Gross Income 2021||Modified Adjusted Gross Income 2022||Contribution Limit|
Single, head of household, or married filing separately (and you didn't live with your spouse at any time during the year)
|Less than $125,000||Less than $129,000||Up to $6,000 to $7,000 per, depending on age|
|Between $125,000 and $140,000||$129,000 to $143,999||A reduced amount available in IRS Guide|
|$140,000 or more||$144,000 or more||Cannot contribute|
Married filing separately (if you lived with your spouse at any time during the year)
|Less than $10,000||Less than $10,000||A reduced amount available in IRS Guide|
|$10,000 or more||$10,000 or more||Cannot contribute|
Married filing jointly or qualifying widow(er)
|Less than $198,000||Less than $204,000||Up to $6,000 to $7,000 per, depending on age|
|Between $198,000 and $208,000||$204,000 to $213,999||A reduced amount available in IRS Guide|
|$208,000 or more||$214,000 or more||Cannot contribute|
Step 5: Start Investing Your Funds
After you’ve funded your account, you can begin investing. There are many investment options, including stocks, bonds, index funds, and mutual funds.
When can I withdraw from an IRA?
Once you reach age 59½, you can withdraw funds from your Traditional IRA without restrictions or penalties.
Can an IRA lose money?
The easiest way to lose money in your IRA is by investing the entire balance of your account on one stock or bond investment, and that investment becomes worthless by that company going out of business.
IRAs are a great way to invest money for your retirement if your employer does not offer a 401k or you want to save a more significant amount than your 401k will allow. The tax benefits of IRAs make them a great asset in your financial portfolio.