IRA definitionIRA is an acronym for individual retirement account. IRAs are tax advantaged investment accounts used for retirement.
An option that can be appealing for people saving for retirement, is to open an IRA at a major brokerage in order to invest in stocks, bonds and mutual funds. Some of these IRAs can be self-directed, which means you'll have a wider selection of investment products available. You can also open an IRA at a bank to keep your retirement in an FDIC-insured account. However, there are limits to FDIC coverage.
"Tax advantaged" means you'll have opportunities to save on your taxes while saving for retirement through an IRA. The tax benefit varies depending on the type of IRA you select. The most well-known types of IRA are the traditional IRA and Roth IRA. Each IRA type has different tax rules that can help you save on taxes at different points in your retirement journey.
Types of IRAsThe IRA was created in 1974 when Congress passed a law called the Employee Retirement Income Security Act (ERISA). The Economic Recovery Tax Act of 1981 expanded the availability of IRAs to all workers. Additional types of IRAs were created through later laws.
Traditional IRAThe original individual retirement account is the traditional IRA. A traditional IRA allows you to save for retirement with pre-tax dollars. This means you don't pay taxes on contributions to your IRA the year you make them. Taxes are delayed until you withdraw from the account, presumably in retirement, and at a lower income tax rate than you pay today. The taxation of a traditional IRA works in a similar way to an employer sponsored 401(k) or 403(b) account, which you may have available through your employer. In fact when you leave your employer you can take your past retirement contributions and earnings with you in a Rollover IRA, which is an IRA funded by past IRA, 401(k), or 403(b) accounts. A major difference between an IRA and a 401(k) is that you can hold your IRA at the financial institution of your choosing, while the 401(k) is held with a custodian designated by your employer plan.
Roth IRAA Roth IRA is an after-tax retirement account. Unlike a traditional IRA that offers tax-free contributions with taxes due upon withdrawal in retirement, a Roth IRA reverses this arrangement. Your contributions are not tax deductible, but qualified withdrawals in retirement are tax free, including investment gains.Like a traditional IRA, a Roth IRA has annual contribution limits based on your age and income. For most people in 2018, the contribution limit is $5,500. For those 50 years of age and above, you can contribute up to $6,500 per year.
Other types of IRAs
Outside of the two primary types of IRAs previously discussed, there are a few other options, primarily for the self-employed. Here are three other types of IRAs you may encounter:
- SEP IRA - A Simplified Employee Pension Individual Retirement Account is an IRA that works more like a 401(k) and allows both employer and certain employee contributions. SEP IRAs are popular for self-employed individuals who don't have a 401(k) available. This is a pre-tax IRA account.
- SIMPLE IRA - A SIMPLE IRA works similarly to a SEP IRA, but is only for companies with under 100 employees. This is also a pre-tax IRA account.
- Nondeductible IRA - Traditional IRAs have income based contribution limits. If you are over the limit, you may be interested in a nondeductible IRA. While it does not offer the same pre-tax contribution benefit of a traditional IRA, investments still grow with the same tax deferred benefits as a traditional IRA once your funds are in the account.
Should I have an IRA?
If you want to save for retirement while also saving on taxes, an IRA can be a useful tool. Even if you have a 401(k) at work, you can save additional funds for retirement with an IRA. However, your IRA contributions may not be deductible. If you are able to contribute up to the limit for both accounts each year, you'll optimize opportunities to build upon a foundation for retirement.
How to get started
One way to open an IRA is with a brokerage firm that gives you access to manage your account online. Be sure to inquire about account fees and other expenses such as commissions. You'll also be required to name a beneficiary for any IRA account, so be sure to have that individual (or individuals) chosen when you're establishing your IRA.
Overall retirement plan
An IRA is just one piece of a retirement plan. Now that you know what an IRA is and how it works, you can consider adding this type of account to your retirement mix. But you don't have to stop there. Remember that a 401(k) is another key part of retirement savings that can allow for tax advantaged investing. Having an IRA could be just one element of a retirement plan.