Learn How Individual Retirement Accounts (IRAs) Work

Senior couple walking in park
Sam Edwards / Getty Images

When you stop working, you’ll still need to pay for food, housing, and other expenses, but where does the money come from if you’re no longer working? There are several potential sources of retirement income, including Social Security benefits and pension income from a former employer. However, you can also save money on your own using personal accounts or an employer-sponsored plan like a 401(k) or 403(b).

What is an IRA?

An individual retirement account (IRA) is an account with tax features that help individuals save for retirement expenses. Also known as an individual retirement arrangement, these accounts can hold the retirement savings from several sources, including contributions that the individual makes to the account and savings that originally came from an employer-sponsored retirement plan.

Types of IRAs

An IRA is a type of account that may look like any other account. But tax features make retirement accounts different from other kinds of accounts. Lawmakers have designed these accounts to promote retirement savings, so there are potential benefits to using the accounts—and there are restrictions to discourage early withdrawals.

There are two types of IRAs, and taxes are handled differently on each one. Before you choose which type of IRA to use or make a contribution, discuss your goals and your situation with a tax professional.

  1. Traditional IRAs provide tax-deferred growth: Income and in the account is not taxed every year like it would be in a standard bank account. Instead, you can reinvest any earnings and take advantage of compounding in the account. You may also get tax benefits in the form of a deduction for money that you contribute to a traditional IRA, allowing you to add “pre-tax” money to the account. However, you might not be eligible for the deduction depending on your income or benefits you receive at your job, so you may need to make after-tax contributions. When you take funds out of the account (to spend it in retirement, for example), any funds that have never been taxed—any pre-tax contributions and earnings— are treated as income in the year you take the distribution.
  1. Roth IRAs provide tax-free growth. Instead of potentially taking a deduction for contributions, you’ll contribute after-tax dollars to the account. When you take distributions in retirement, you receive all of the money tax-free (assuming you satisfy all IRS requirements). In other words, you get your original contributions and any earnings tax-free. Roth IRAs have additional restrictions, including a five-year waiting period and income limits that may prevent you from contributing. That said, you can generally take your contributions back out of a Roth at any time without taxes or penalty—but you may have tax consequences if you remove earnings from the account.
  2. Rollover IRAs are traditional IRAs that receive funds from another retirement account. For example, you might roll pre-tax 401(k) assets into a rollover IRA. In the past, those assets might have been kept separate, but combining assets is currently the norm.
  3. Employer plans like SEPs and SIMPLEs are also technically IRAs. They have features that are similar to traditional IRAs, but the rules are different because they are designed for small businesses or self-employed individuals. Contribution limits are higher, and some employees might not be required to take distributions from the account while still working for the employer.

    Tax Features

    These accounts can help you save a significant amount of money for retirement. However, IRS rules limit tax benefits so that the U.S. Treasury continues to receive funding. This page provides an introductory overview, but it is not a complete list of rules. There are always complications and easy-to-miss details, and several sophisticated strategies may allow you to legally work around some of the rules. Visit with a tax professional to get individualized advice on how to manage your savings.

    Contribution limits: The IRS limits the maximum amount you can contribute to a standard IRA every year. For 2017 the limit is $5,500, but that number changes from time to time with inflation adjustments. For those over the age of 50, an additional “catch up” contribution of $1,000 is allowed.

    Rollovers and transfers from other retirement accounts generally do not count against those limits, but there are complicated pitfalls with transfers—so talk with an expert before you move money.

    Early withdrawals: IRAs are designed to fund retirement. While you’re allowed to retire at any age, the IRS uses age 59 ½ as the age at which you can avoid certain tax penalties on withdrawals from IRAs. You can take distributions before then, but you may have to pay tax penalties (in addition to income tax) for early withdrawals unless you meet certain criteria or use advanced strategies. That penalty is typically 10 percent of the amount you withdraw, but it can be 25 percent for SIMPLE IRA plans.

    RMDs: Because you have pre-tax money in traditional IRAs, you eventually need to start taking money out and generating tax revenue. After age 70 ½, the IRS mandates Required Minimum Distributions (RMDs) from traditional IRAs, which are designed to draw down your account over your life expectancy. Roth IRAs do not have RMDs for the original contributor, but inherited Roth IRAs must use RMDs.

    Pre-tax or post-tax? The ability to deduct contributions to a traditional IRA has been an appealing feature for decades. Savers can potentially reduce their taxable income, which makes it easier to afford contributing. However, they’re choosing to pay taxes later instead of today. Whether or not that makes sense is an unknown—we don’t know what tax rates will look like in the future, or how the tax system might change in unanticipated ways. Roth IRAs allow savers to prepay taxes, but again, there are several unknowns (such as where tax rates will go, how the rules might change, and more). If you’ve got more in traditional accounts than you’d prefer, you can convert assets from a traditional IRA to Roth, but there may be unexpected tax consequences for doing so.

    Investments in IRAs

    An IRA is just a type of account with tax features. Those features do not have a significant impact on your choices for investments—think of an IRA as a “wrapper” around any other account you’re familiar with.

    While there are some exceptions, you can use almost any type of mainstream investment vehicle inside of an IRA, including cash in savings accounts, certificates of deposit (CDs), riskier investments like mutual funds or ETFs, and more. The right investment for you will depend on several factors, including your goals and your ability to take risks with your savings.

    Where to Open an IRA

    You can open an IRA at banks, credit unions, investment firms, and other financial institutions. Ask any provider about the types of investments available, annual custodial fees and other expenses, and other features to determine where you should open your IRA.

    Important Information

    Tax laws are complicated, and things may have changed since this article was originally written. It’s essential to verify the facts for yourself before making decisions about your money. Check with the IRS or visit with a professional tax advisor. This article is written without any knowledge of your situation or your goals, so do not rely on it as financial advice. Hopefully, you have some food for thought when you visit with your CPA or tax professional.