What Is an IRA and How Does It Work?

What Is an IRA and How Does It Work?

When saving for retirement, you'll want to take special care to make smart money decisions up front, as these funds can grow over long periods of time. Because of this, it's best to understand the various accounts that are available so you can maximize your retirement savings in a tax-efficient way, such as with an IRA.

What is an IRA? Also known as an individual retirement account, IRAs allow taxpayers to save money in an account that offers tax breaks, making the account a useful way to save money for retirement. Many people mistakenly think an IRA is a type of investment when in fact it's an account that allows you to buy stocks, bonds, mutual funds and other assets.

IRAs differ from 401(k) plans, which are the accounts many companies offer employees. These employer plans require you to work for a company and can come with various rules about vesting, access and investment options. IRAs, on the other hand, are accounts you can open on your own and come with more available investment options.

Let's learn more about IRAs and how they work.

What Is an IRA?

An IRA is a type of tax-deferred or tax-free retirement savings account that's offered by many financial institutions. IRAs provide tax benefits so your retirement savings can grow and compound more than it otherwise would be able to in a taxable account. They also offer greater flexibility for investment options than 401(k) plans, which often offer a limited menu of assets.

If you want to begin saving for your retirement, IRAs are well worth considering. Anyone with earned income can open an IRA and contribute as long as it's at or below the maximum annual contribution limit — $6,000 in 2020 or $7,000 if you'll be age 50 or older at any time during the calendar year.

How Does an IRA Work?

IRAs offer tax advantages for retirement savers. They allow you to invest money in a number of items, including stocks and bonds, real estate, certificates of deposit, alternative investments and more.

You can open an IRA at a bank or with a broker. When you invest through an IRA, the money often must stay in the account until you reach age 59 1/2.

Generally, retirement savers choose a portfolio of stocks and bonds because of their greater historical returns. This allows you to grow your retirement funds over time.

Different Types of IRAs

Four main types of IRAs are currently available: Traditional, Roth, SEP and SIMPLE. However, there are also other types to consider as well, including a backdoor Roth, inherited, rollover, self-directed and spousal IRAs.

Because the four main types are most common, let's take a closer look at them.

  1. Traditional IRA: A traditional IRA is an account that allows investments to grow on a tax-deferred basis with contributions that can be tax-deductible. That means if you earn under a certain income limit, the contributions you make can lower your taxable income, saving you money each year on your taxes. The money grows tax-deferred because you don't pay taxes on the money until you withdraw it during retirement.
  2. Roth IRA: A Roth IRA is an account that allows your money to grow tax-free, meaning you pay taxes on the money up front when you earn it and the funds don't need to have more taxes paid when you withdraw them. This type of individual retirement account has an income cap, however, which prevents high earners from contributing.
  3. SEP IRA: SEP stands for "simplified employee pension" and these accounts are useful to have for small-business owners and self-employed individuals. These are similar to traditional IRAs, which have retirement savings grow tax-deferred with withdrawals taxed at your marginal income tax rate (with the top rate paid on earned income). However, SEP IRAs come with much higher maximum annual contribution limits ($57,000 in 2020) than traditional IRAs ($6,000 in 2020).
  4. SIMPLE IRA: SIMPLE IRAs, or "savings incentive match for employees" IRAs, act as less expensive and complicated retirement accounts that small companies with 100 or fewer employees can offer. These plans require employers to contribute and, unlike SEP IRAs, employees can also contribute their own money (up to $13,500 in 2020 and an extra $3,000 for individuals 50 and older).

Are There Penalties for Early Withdrawals?

With traditional IRAs, you can't withdraw your money before age 59 1/2 without incurring a 10% penalty and tax bill unless you qualify for an exception. Such exceptions include using IRA funds to pay for your medical insurance premiums after a job loss, electing to take a hardship distribution and more.

In the case of Roth IRAs, however, you have some withdrawal flexibility, allowing you to access your contributions earlier but not your investment earnings, per the IRS. The IRS allows you to take out your contributions at any time without paying taxes or the 10% penalty.

Of course, this decision should not be made lightly. Making an early withdrawal could cause you to lose the potential returns on your retirement nest egg.

How Do IRAs Differ From 401(k)s?

An IRA is not the same thing as a 401(k). Despite the fact that you can save for retirement with both accounts, only employers can offer you access to a 401(k). IRAs are available to all individuals who have earned income during the year.

401(k) plans have larger contribution limits ($19,500 in 2020 with a $6,500 catch-up contribution if you're 50 or older), which allows employers to make contributions to your account in addition to the contributions you make. IRAs, on the other hand, aren't tied to an employer and only have the contributions that were made by you.

If you have access to both plans, you may contribute to both at the same time. If your employer offers a 401(k) match, you might consider placing enough money into the account to get the maximum match before contributing to your IRA. This match offers a guaranteed return on your money. For example, some employers may promise a 100% match on the first 4% of your salary you contribute. That means if your salary is $50,000, your employer will put in $2,000 as long as you contribute at least $2,000.

Once you exhaust this match, you can switch your contributions to your IRA for the year until you reach the limit. From there, you can resume the contributions to your 401(k). If your employer doesn't offer a match, consider skipping the 401(k) and maxing out your IRA prior to putting money in the employer-sponsored account.

Why You Should Consider Opening an IRA

When you retire, you'll need enough income to meet your retirement needs, and having money invested in an IRA is one way to make that happen. When combined with other income sources, IRAs can help you reach your retirement goals because you'll have a portfolio of investments at your fingertips.

If you decide an IRA could be right for you, adding the account to your retirement plan could give you additional peace of mind.

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