An individual retirement account (IRA) is a savings account that offers tax benefits and is designed for people with earned income to save for their future.
The IRA is mainly for self-employed individuals without access to employer-sponsored retirement accounts like the 401(k). But even those with a workplace retirement plan can still open an IRA to save more for retirement.
You have the option to start an IRA with a bank, an investment firm, an online brokerage, or a personal broker.
How IRA Works?
People who earn income can start and add money to an IRA, even if they already have a 401(k) from work. The only restriction is on the total amount you can put into retirement accounts each year.
The top IRA accounts allow you to invest in various financial products like stocks, bonds, ETFs, and mutual funds.
Self-directed IRAs (SDIRAs) allow investors to control their own investment choices. They provide a wider range of investment options, such as real estate and commodities. The only investments that are not allowed are the riskiest ones.
Different IRAs have various rules for who can participate, how they are taxed, and when money can be taken out. Some examples are:
- Traditional IRAs
- Roth IRAs
- Simplified Employee Pension (SEP) IRAs
- Savings Incentive Match Plan for Employees (SIMPLE) IRAs
Regular people can open traditional and Roth IRAs. Business owners and freelancers can create SEP and SIMPLE IRAs.
An Individual Retirement Account (IRA) needs to be started with a financial institution that is authorized by the IRS to provide these accounts. Options include banks, investment firms, credit unions with federal insurance, and savings and loan associations.
IRAs are designed for investing and growing funds for retirement, so if you withdraw money before age 59½, you’ll face a 10% penalty along with taxes on the amount you take out.
There are some important exceptions to the penalty rule, such as withdrawals for education costs and buying a first home, among others.
Money in a Roth account is already taxed, so you won’t owe any more taxes when you take it out.
Conclusion
IRAs are accounts for saving for retirement that have tax benefits. They are similar to 401(k)s, but do not need an employer to set them up. There are different types of IRAs: traditional, Roth, SEP, and SIMPLE.
There are income limits for deducting contributions to traditional IRAs and for contributing to Roth IRAs, which means there is a maximum amount of tax savings you can get from investing in an IRA.
IRAs are designed for long-term retirement savings. If you take money out early, you go against the purpose of saving for retirement by reducing your retirement funds. This is why money in an IRA usually cannot be withdrawn before age 59½ without facing a significant tax penalty of 10% of the withdrawn amount (in addition to regular taxes).