How IRAs Work

Understanding Individual Retirement Accounts

How IRAs hold the golden egg.
Learn where IRAs stand among retirement accounts. (c) Andy Roberts, OJO Images, Getty Images

An individual retirement account (or individual retirement arrangement) is a tax-favored investment account designed to help individuals save for retirement. There are many different types of IRAs, but the two distinct types are traditional IRAs (usually referred to simply as IRAs) and Roth IRAs. We'll discuss Roth IRAs a little later on. To start, let's get to know the basics of traditional IRAs.

 

You can open a traditional IRA through an account provider or online brokerage as long as you are earning income and are younger than age 70 1/2. Money that goes into an IRA, otherwise known as contributions, can be invested in any way that the IRA account holder chooses. Depending on where you invest, you should have a broad range of stocks, bonds, mutual funds, and other types of equities to choose from. In theory, anything you can invest in can be invested in through an IRA. 

IRAs and Taxes 

Contributions to a traditional IRA may be tax-deductible, depending on whether you have another retirement account through work.

Investments in an IRA grow tax-deferred, meaning the account is not taxed as long as the money is held inside the account. Once you take the money out, otherwise known as taking distributions, you will pay taxes on the contributions and earnings. The idea is that in retirement your income may actually be lower, so the taxes you pay will potentially be less significant than what you would pay during your working years.

You can withdraw money from an IRA at any time, but if you take the money out before retirement age (currently at least age 59 1/2), you will not only pay taxes but could also face a 10% early withdrawal penalty. There are some exceptions to the early withdrawal penalty, depending on whether you meet certain qualifications.

 You must start taking at least minimum distributions from your account by age 70 1/2. 

IRA Contribution Limits

There are limits to how much you can put into your IRA each year. These limits change over time, adjusting every year or two with inflation. There are additional catch-up contributions available to investors age 50 or older, designed to accelerate savings growth in the pre-retirement years. (Find out more about 2017 IRA contribution limits.) You have until the tax filing deadline to make contributions. For example, you can make 2017 IRA contributions anytime before April 16, 2018. If you file an extension, you may have even longer than that. 

Other Types of IRAs

There are also self-employed IRAs, the SEP IRA and SIMPLE IRA. These work in similar ways to the traditional IRA but have different contribution limits and other rules. 

A rollover IRA is a traditional IRA that can be used to house other tax-favored investment accounts without tax penalty. For example, if you are leaving a job and need to move your 401(k) account, a rollover IRA is place to do it. 

How Roth IRAs Are Different 

A Roth IRA is similar in many ways to a traditional IRA, including contribution limits, how to open an account, and how contributions can be invested.

 But in other ways Roth IRAs are distinctly different. The big difference is instead of putting tax-deductible money into the account to grow tax-deferred, Roth IRA contributions are made after tax. Once in the account, contributions and earnings within a Roth grow tax free. Even after the money is withdrawn at retirement, it is withdrawn tax free. (As long as the distributions are considered qualified distributions.)

There are a few other differences. Your adjusted gross income must be below a certain level to contribute to a Roth IRA. You can make contributions to your Roth IRA after you reach age 70 ½. There is also no requirement to take minimum distributions from a Roth as long as you are the original account holder. And you may be able to withdraw contributions (although not earnings) from a Roth IRA before retirement without paying a 10 percent penalty.

 

You can have more than one IRA, including a traditional, a SEP or SIMPLE, and a Roth, as well as your 401(k). You can even convert a traditional IRA to a Roth, depending on whether you think that doing so will save taxes for you in the future. 

The content on this site is provided for information and discussion purposes only. It is not intended to be professional financial advice and should not be the sole basis for your investment or tax planning decisions. Under no circumstances does this information represent a recommendation to buy or sell securities.

Updated by Scott Spann