What Is an IRA and How Does It Work?

Similar to 401(k)s, Individual Retirement Accounts (IRAs) are tools used to plan your and your family’s future. With several different accounts to choose from, knowing how IRAs work, the associated advantages and disadvantages and how to get started with a plan will set you up for future success. Retirement should be something you look forward to, and achieving that positive mindset is possible through powerful investment tools like IRAs.

But what is an IRA and how do they work?

What is an IRA?

IRAs are tax-advantaged retirement accounts comprised of stocks, bonds, mutual funds, private placements, real estate, tax liens and/or exchange-traded funds (ETFs). Unlike 401(k)s, these accounts are not company-sponsored and do not require traditional employment to take advantage of. You can choose to manage your own IRA or seek professional assistance. Regardless of who is making the trading decisions, your IRA must be purchased through an institution certified through the IRS, which typically includes banks, credit unions and brokerage firms.

As IRAs carry tax advantages, there are annual contribution limits. For those under the age of 50, this amount is $6,000. People over 50 years of age can contribute $7,000 annually thanks to a catch-up clause in IRS tax codes. Additionally, you may have the option of opening an IRA for your spouse, even if they did not work during the year. This would increase your total allowed contribution amount and also potentially offer more tax savings.

Tax savings for IRAs are dependent on the type of plan you select, if you are married, filing separately or jointly and whether you are covered by a retirement savings plan at work. As each unique case is different, it’s best to check the specifics on your deduction eligibility at the IRS website.

For those that are eligible for deductions, the tax burden will further be contingent on the IRA selected. Traditional IRAs allow investors to defer taxes until the funds are distributed later in life. This is ideal for those expecting to be in a lower tax bracket in retirement, which is common. Roth IRAs, on the other hand, are taxed at the current rate of income and are ideal for people expecting to be in a higher tax bracket during retirement.

Determining the amount of money you need to have saved in your IRA and other retirement assets before your last day of work will depend on several factors. These factors include, but are not limited to, the age you plan to retire, the quality of life you desire, expected expenses, eligibility for government assistance programs like social security and potential retirement income. As there is no single right answer for the amount of money you need for retirement, a good starting point is a retirement calculator. For the most complete information, you will want to contact an investment professional.

IRA alternatives

401(k)s

For those employed with an employer offering retirement savings plans, though, you may want to compare the benefits of an IRA with the benefits of the company-sponsored 401(k). If fund matching is available with your 401(k), your primary retirement plan should be taking advantage of that. Do keep in mind that utilizing multiple retirement instruments is allowed and does offer the ability to realize more tax savings and overall benefits.

Savings accounts

Additionally, don’t discount using more traditional financial instruments for retirement planning like traditional savings accounts and high-yield savings accounts. While you might not receive all of the same tax benefits as an IRA or 401(k), these easier-to-understand account types are still an effective way to get started. Savings accounts are also lower risk than many IRA portfolios making them an attractive option.

Savings accounts can be used in conjunction with other traditional retirement vehicles, with no taxes, withdrawal penalties or contribution limits. However, savings accounts are low-risk, and savers shouldn’t expect to see high returns, even on accounts with 2% APY. Starting early with savings is a way to ensure a safety net on the path to retirement.

Using IRA funds

Traditionally, withdrawal from IRA funds begins once you’ve reached the age of 59 ½. You’re not required to begin taking disbursements at this age, but you will be required to shortly after the age of 70 ½. Funds can be taken out as a lump sum or in regular or non-regular payments. Depending on the type of IRA you chose — Roth or traditional — you may or may not owe taxes.

For those that need access to funds earlier than this age, there are options available. However, you may lose out on the money gained from tax benefits due to early withdrawal penalties. Unlike 401(k)s, there are no IRA loan options available.

Despite this, your options do include IRA rollovers (similar to a very short-term loan) and specific need/hardship withdrawals subject to a 10% early withdrawal penalty. There are instances where you can avoid the early withdrawal penalty if you’re permanently disabled, are making a qualified higher-education expense, unreimbursed medical expenses, unemployed health insurance premiums and up to $10,000 for qualified first-time home purchases.

Additionally, Roth IRA holders can withdraw funds without penalty as they have already paid the necessary taxes on the contribution. Do keep in mind, though, if you withdraw investment earnings from your account, you will be subject to the early withdrawal penalty. Funds withdrawn the same year they were contributed and before the tax-filing deadline do not count toward the contribution limits. In other words, you’re able to put that money back if you choose.

Ideally, IRAs are designed to be used for retirement. While it’s understandable that life does happen from time to time, drawing funds from retirement accounts should be a last resort. Additionally, ensure you understand all the implications before doing so, especially in the instance of a bankruptcy or other creditor issue. Some retirement funds are protected as long as they are in an IRA or retirement account and meet certain qualifications.

The final word

Preparing for retirement does not have to be a worry-filled adventure. By utilizing the powerful financial tools available to you like IRAs, you can set yourself and your family up for a peaceful and enjoyable later chapter of life. There is no time like the present to plan for the future. Make sure you utilize the provided information here and do what’s necessary to understand fully the investment options you have available. Even small contributions today will have a marked impact on your future retirement.