What Is an IRA and How Many Types of IRAs are There?
IRA Stands for Individual Retirement Account
An IRA is retirement fund lingo for "Individual Retirement Account." If you don't have one, you're missing out on additional retirement income that gets investment more on your terms instead of having to choose between a few company funds. It's a powerful took that too many people aren't utilizing.
Is an IRA an Investment?
People frequently ask how to find the best interest rates on an IRA, but an IRA is not an investment. It is a type of account. Inside that account you can invest in many different types of things—far more than your company-sponsored 401(k).
You can open an IRA account at a bank, brokerage firm, mutual fund company, insurance company and at various other types of financial institutions. You can use the money you deposit into your IRA to invest in CDs, government bonds, mutual funds, stocks, and almost any other type of financial investment you can think of.
There are two main types of IRAs:
- Traditional IRAs
- Roth IRAs
The two categories above refer to the tax rules that regulate that type of IRA.
- As a sub category of Traditional IRAs, you can have non-deductibles, spousal IRA contributions, SEP IRAS and SIMPLE IRAs.
- As a sub category of Roth IRAs you can have Roth spousal IRA contributions. There is also a Roth 401(k) option called a Designated Roth account.
What Is a Traditional IRA?
Traditional IRAs were introduced by Congress in 1974 through the Employee Retirement Income Security Act as a way to encourage people to save for retirement by offering special tax treatment for funds that you put into IRAs.
Tax Treatment of a Traditional IRA
Contributions to a Traditional IRA may be tax deductible if you meet certain eligibility requirements. If you are not eligible to make a tax-deductible IRA contribution you may still make a non-deductible IRA contribution.
You have to have earned income to contribute to any type of IRA—with one exception. If you are married as long as you have enough earned income you can contribute to a spousal IRA for a spouse even if they have no earned income.
Traditional IRA Quick Facts
- Funds inside of an IRA grow tax deferred. This means you do not pay income taxes on interest, dividends and capital gains until such time as you take a withdrawal.
- There is a penalty imposed on early IRA withdrawals which is a withdrawal that occurs before age 59 ½. The penalty is 10% plus income tax payments so try not to take any early withdrawals unless absolutely necessary.
- You must begin taking required minimum distributions by age 70 ½.
What Is a Roth IRA?
Roth IRAs are a new type of IRA introduced through the Taxpayer Relief Act of 1997. Roth IRAs have different tax rules than Traditional IRAs.
Tax Treatment of a Roth IRA
Contributions to a Roth IRA are not tax deductible, but funds inside of a Roth IRA grow tax free. This means you will never pay income taxes on interest, dividends and capital gains on funds that accumulate inside of a Roth IRA as long as you follow the Roth IRA withdrawal rules. In other words, with a traditional IRA, you pay taxes when you retire and withdrawal the funds. With a Roth IRA, you pay the taxes now, before you contribute to your plan. The advantage to this is that later in life, your individual tax bracket might be higher along with the overall tax rates.
Roth IRA Quick Facts
- Funds inside of an Roth IRA grow tax free. This means you do not pay income taxes on interest, dividends and capital gains earned—ever (assuming you follow the rules).
- You can withdraw amounts contributed to a Roth right back out with no penalty taxes owed. This means a Roth IRA can double as your emergency fund.
- Roth IRAs do not have required minimum distributions at any age.
- You can convert a Traditional IRA to a Roth. Note: rules on conversions are different than rules on contributions.
IRA Withdrawal Rules
Although there are steep penalties for early withdrawals, there are exceptions that apply. You can use some of your account balance to pay medical bills up to a certain amount, if you're disable, and to pay health insurance premiums and higher education expenses. Even a first time home purchase is allowable.
Each of these have plenty of rules that you must know and understand first. Also, just because you can doesn't necessarily mean you should. You will lose the earning power of that money if you withdrawal the funds so weigh the decision very carefully.
IRAs for Self-Employed Persons or Business Owners
If you own a business or work as a self-employed independent contractor you may be eligible to establish either a SEP IRA (best for those with no employees) or a SIMPLE IRA (which may work better if you have employees.)
Either of the above plans may allow you to make a larger contribution than what you could make to a traditional or Roth IRA.