What is an IRA? Types of IRAs and how they work
An individual retirement account (IRA) is a personal savings account designed to help people prepare for retirement. It’s also known as an individual retirement arrangement. And there are several types of IRAs.
What you’ll learn:
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An IRA is a retirement account set up by individuals rather than employers.
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The three main types of IRAs are traditional IRAs, Roth IRAs and rollover IRAs.
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Traditional IRAs are funded with pretax dollars, and Roth IRA contributions are made after taxes.
- A rollover IRA is funded with money from a former employer-sponsored 401(k).
What is an IRA?
An IRA is a savings account designed to help people save for retirement. In general, anyone with earned income is eligible to open one.
How does an IRA work?
After you open an IRA, there are a few key steps you might follow.
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Add funds: Make deposits, or contributions, into your IRA. You might be able to do this by check, bank transfer or direct deposit. The Internal Revenue Service (IRS) has guidelines for the amount you can contribute depending on age, income and the type of IRA.
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Invest: Once an IRA is funded, you might decide how to invest. Options might include certificates of deposit (CDs), stocks, bonds, mutual funds and exchange-traded funds. To decide which is right for you, you can consider financial goals and retirement timelines. There may be options to manage your own investments or get help by working with a financial adviser, using a robo-adviser or choosing a target-date fund. That’s a type of fund that automatically adjusts your investments and tends to become more conservative the closer you are to retirement.
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Withdraw: You can withdraw funds, or take distributions, from an IRA after reaching retirement age, defined by the IRS as 59 ½. There could be penalties for withdrawing earlier.
Types of IRA accounts
IRAs offer tax advantages. But when they apply depends on the type of IRA.
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Traditional IRA: Contributions to a traditional IRA are usually made with pretax dollars that can be tax deductible depending on income and tax filing status. Generally, account holders pay income tax on withdrawals when they reach 59 ½. Withdrawals made before that may incur a 10% penalty.
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Roth IRA: Contributions are made with after-tax dollars. Those contributions aren’t usually tax deductible. Roth IRAs may have additional eligibility requirements, such as income and tax filing status. Distributions claimed after age 59 ½, including any account growth, are typically tax- and penalty-free.
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Rollover IRA: A rollover IRA is an IRA that’s been rolled over from another retirement account, usually a former employer-sponsored 401(k), after a worker changes jobs and no longer participates in the old plan. If the funds are transferred from a traditional 401(k) to a traditional IRA, account holders usually won’t have to pay penalties or taxes. If the rollover is from a traditional IRA or 401(k) to a Roth IRA, the funds may be subject to taxes.
- Other IRAs: Simplified employee pension (SEP) IRAs and savings incentive match plan for employees (SIMPLE) IRAs are usually for self-employed individuals and small-business owners. The rules and annual contribution limits for SEP IRAs and SIMPLE IRAs are different from those of traditional and Roth IRAs.
Key differences between traditional and Roth IRAs
Here’s a quick overview of the differences between traditional and Roth IRAs:
| Traditional IRA | Roth IRA | |
| Tax status of contributions | Before tax | After tax |
| Taxed withdrawals | Yes | No |
| Taxed earnings | Yes | Only if withdrawn before age 59 ½ |
| Income-based contribution limits | No | Yes |
| Tax-deductable contributions | Income dependant | No |
| Minimum distribution | Yes, starting at age 70 ½ | No |
| Early withdrawal penalties | 10% on contributions and earnings | 10% on earnings |
How to open an IRA
You can expect these general steps when you open an IRA:
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Select a provider. Banks, credit unions, online brokerages and insurance agencies offer IRAs.
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Choose an IRA. Your decision between a traditional and a Roth IRA may depend on your income, estimated retirement age and anticipated tax rate in retirement. If you’re unsure, you can ask a tax adviser.
- Open an account. Providers might require documentation and personal information, such as a Social Security number (SSN), government identification, date of birth and address.
IRAs and how they work FAQ
Here are some answers to frequently asked questions about IRAs.
Is a 401(k) the same as an IRA?
IRAs and 401(k) plans are both retirement savings accounts. But an IRA is an individual retirement account set up by the account holder, and a 401(k) is a retirement account from an employer.
You can contribute to both types of accounts. Many employers will make matching 401(k) contributions up to a certain percentage of an employee’s income. Because IRAs are generally set up by individuals, there’s usually no employer match.
What are the downsides of an IRA?
The IRS has a few rules for IRAs that could incur a penalty if not followed.
- Contributions: There’s a maximum amount you can contribute to your IRA annually.
- Withdrawals: You can withdraw funds starting at age 59 ½.
- Distributions: From age 73 onward, you must take at least the required minimum distribution (RMD) annually from any traditional IRA.
Key takeaways: IRAs
Saving money for retirement in an IRA can help people enjoy a secure financial future while also taking advantage of tax benefits. And for those who already have 401(k) plans through their employers, opening an IRA can serve as an additional place to save even more money for retirement.
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