What Is An IRA?: Types & How They Work | Bankrate (2024)

An IRA is a tax-advantaged investment account that you can use to save for retirement. Technically, IRA stands for Individual Retirement Arrangement, but the ‘A’ in the acronym is colloquially referred to as an account.

IRAs are particularly valuable tools for the 33 percent of private industry workers in the U.S. who do not have access to a workplace-based retirement plan. Too often, that lack of a 401(k) from an employer means that people don’t save for retirement, but IRAs give all workers a convenient way to prepare for their golden years.

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IRAs come in two flavors: traditional and Roth. There are two fundamental differences between them: whether you pay taxes before contributing (Roth) or after withdrawing funds (traditional) and when you need to withdraw funds from these accounts.

It’s important to note that IRAs can also be ideal for the 67 percent of people who do have access to a workplace-based plan. If you’re maxing out your contributions there or you simply want another option with more control over your investment, an IRA can present a great way to save even more money for retirement.

How does an IRA work?

Using an IRA versus a regular taxable brokerage account for retirement feels similar to the difference between speeding through the E-Z Pass lane on the highway or stopping at the toll booth every 20 miles: You’re going to get where you want to go a bit faster without having to stop at the tax tollbooth every year as you would with a regular brokerage account.

When you open an IRA, you contribute funds that can then be invested in a wide range of assets — CDs, stocks, bonds and other investments. You’re not limited to a menu of investments as you often are in a 401(k). That means you can take full control of picking how this account is invested. If you don’t feel well equipped to choose investments for your IRA, it’s wise to browse robo-advisors or pick a target-date retirement fund. Both are low-cost ways to get broad-based diversification tailored to your time horizon and your risk tolerance.

No matter when you’re hoping to retire, today’s asset allocation — how you split your money between stocks, bonds and other investments — is absolutely critical to tomorrow’s earnings. In fact, some studies have shown that asset allocation determines as much as 90 percent of an investor’s total return. IRAs offer flexibility in adjusting those investments, too. You can move in and out of them — for example, shifting your money from individual stocks to bonds — without incurring capital gains taxes.

While you can move the money around freely, you can’t take it out early. An IRA is designed for retirement, which means that withdrawals before you are 59 1/2 will incur both taxes and a hefty penalty of 10 percent — unless you’re using the money for special exceptions such as buying your first home or paying for higher education (and those exceptions come with caveats).

Types of IRAs

IRAs come in two flavors: traditional and Roth. There are two fundamental differences between them: whether you pay taxes before contributing or after withdrawing funds, and when you are required to withdraw funds.

Traditional IRA

With a traditional IRA, you could be eligible to receive a tax deduction in the year you make the contribution (up to a cap on the contribution of $7,000, or $8,000 if you’re 50 or older). When you withdraw the funds later, you’ll pay taxes on the full amount you are withdrawing. Once you turn 73, you must start making withdrawals.

Roth IRA

A Roth IRA doesn’t offer the instant gratification of an immediate tax break. Instead, you’ll pay taxes on your income now, contribute it to a Roth IRA and avoid taxes when you withdraw the proceeds when you retire. However, there is no requirement to make withdrawals from a Roth IRA.

When comparing traditional and Roth IRAs, it’s fairly common to think about current tax status versus your tax status in retirement with the assumption that you’ll be in a lower tax bracket when you are no longer working.

However, it’s recommended you avoid that debate. Why? Because it’s very difficult to predict your tax bracket 30 years from today. Instead, look at this from the perspective of diversifying your tax exposure and giving that money even more time to grow and compound without the headwind of taxes. Regardless of your future tax bracket, having some assets accumulated in a Roth IRA that can later be withdrawn tax-free is worth considering.

SEP IRA

A SEP IRA is an account that’s available to the self-employed or business owners. It offers the tax advantages of an IRA, and the employer can contribute the lesser of 25 percent of income or $66,000 (for 2023) – much more than what workers alone can set aside in a regular IRA.

SIMPLE IRA

A SIMPLE IRA is another type of employer-sponsored retirement plan for the self-employed or business owners. Employees can defer their salary to their account, and employers must contribute to the account. The contribution limit for employees is $16,000 (in 2024). If your plan allows it, employees aged 50 and older can make catch-up contributions of up to $3,500.

How to open an IRA

To open an IRA, you or your spouse need to have earned income from working. You can open an IRA at a wide range of places including brokerage firms, mutual fund companies, banks and credit unions. Pay attention to management fees, commissions and minimum opening requirements to make sure you find a good deal.

And in addition to the basic terms of each IRA, compare educational resources if you plan on being in the driver’s seat making your own investing decisions. Some firms offer robust tools to help you understand the market and make wise choices.

IRA contribution limits

The government places limits on the amount you can contribute to all your IRA accounts, which change every few years based on inflation. If you’re under age 50, your contributions are capped at $7,000 in 2024. If you’re over 50, your limit increases to $8,000.

Before you think about how to maximize your IRA contributions, though, you need to make sure that your annual earnings fall within the government’s threshold. Your deduction capability begins to phase out as your income increases. The limits vary based on your filing status, so check the IRS’ updated guidelines to verify your eligibility.

Comparing IRA options

The most affordable options for IRAs will be found at no-load mutual fund firms, online brokerages and robo-advisors. Before comparing and deciding where to open an IRA, you should consider which kind of IRA is the best fit for your needs. Keep in mind, too, that the decision between a traditional and Roth IRA is not an all-or-nothing choice. You can have both — you’ll just want to make sure your annual contributions don’t exceed the limits.

Type of IRAAnnual contribution limitCan you deduct the contribution on your taxes?Can you withdraw the money tax-free?When do you have to start withdrawals?
Traditional$7,000 if under age 50; $8,000 if over 50Yes (subject to income limitations)NoAge 73
Roth$7,000 if under age 50; $8,000 if over 50NoYesNever

Is it better to have a 401(k) or an IRA?

Both a 401(k) and IRA offer key advantages for those looking to save for retirement. But when it comes down to it, a 401(k) is better than an IRA for several reasons, in particular because of higher contribution limits and the ability to receive a company match, which is like free money.

A 401(k) allows workers to save up to $23,000 (for 2024), compared to just $7,000 in an IRA. And it does better for catch-up contributions, too. For those 50 and older, the 401(k) lets you contribute an additional $7,500, while the IRA has a more modest $1,000 catch-up limit.

A 401(k) may also come with a company matching contribution, meaning that you’ll receive money from your employer if you add to your account. Typically, you’ll receive 50 to 100 percent of your contribution, up to three to five percent of your salary, depending on your plan. It’s an easy way for you to generate an immediate and risk-free return on your money, and experts routinely advise workers to be sure to get the entire company matching contribution.

What Is An IRA?: Types & How They Work | Bankrate (2024)

FAQs

What are the main types of IRAs and how does each work? ›

Traditional and Roth IRAs can be opened by individuals. SEP IRAs and SIMPLE IRAs are usually opened by self-employed individuals and small-business owners. The rules and annual contribution limits for SEP IRAs and SIMPLE IRAS are different from traditional and Roth IRAs.

What is an IRA simple explanation? ›

An individual retirement account (IRA) is a tax-advantaged investment account that helps you save for retirement. The IRS sets maximum contribution limits for IRA accounts each year.

What definition best explains an IRA? ›

An IRA (individual retirement account) is a personal, tax-deferred account the IRS created to give investors an easy way to save for retirement.

What is an IRA and what are its pros and cons? ›

What Are the Benefits and Drawbacks of IRAs?
  • IRAs are tax-advantaged. ...
  • IRAs have more investment options than 401(k) plans. ...
  • IRAs are more flexible and liquid than you might think. ...
  • IRAs can often have lower fees than 401(k) plans. ...
  • IRAs have low annual contribution limits. ...
  • IRAs sometimes have early withdrawal penalties.
Feb 16, 2024

What is IRA and types of IRA? ›

Individual retirement accounts (IRAs) are retirement savings accounts with tax advantages. Types of IRAs include traditional IRAs, Roth IRAs, Simplified Employee Pension (SEP) IRAs, and Savings Incentive Match Plan for Employees (SIMPLE) IRAs.

What are the different types of IRA? ›

With a Roth IRA, you contribute after-tax dollars, your money grows tax-free, and you can generally make tax- and penalty-free withdrawals after age 59½. With a Traditional IRA, you contribute pre- or after-tax dollars, your money grows tax-deferred, and withdrawals are taxed as current income after age 59½.

Which is the best type of IRA? ›

Retirement experts often recommend the Roth IRA, but it's not always the better option, depending on your financial situation. The traditional IRA is a better choice when you're older or earning more, because you can avoid income taxes at higher rates on today's income.

What is an example of a SIMPLE IRA? ›

Example of a SIMPLE IRA

Imagine you earn $60,000 a year, and your employer matches the contributions you make for up to 3 percent of your salary. You would like to save a total of 10 percent of your salary, including the match. So you decide to defer 7 percent of your own pay in each paycheck.

How does IRA make money? ›

Whenever the investments in your account earn a dividend or interest, that amount is added to your account balance. How much the account earns depends on the investments that they contain. Remember, IRAs are accounts that hold the investments you choose. (They are not investments on their own.)

What is the primary purpose of IRA? ›

IRAs allow you to make tax-deferred investments to provide financial security when you retire.

Can you take money out of an IRA? ›

You can take distributions from your IRA (including your SEP-IRA or SIMPLE-IRA) at any time. There is no need to show a hardship to take a distribution. However, your distribution will be includible in your taxable income and it may be subject to a 10% additional tax if you're under age 59 1/2.

Is IRA good or bad? ›

In the short term, it effectively makes it “cheaper” to save for retirement, since the tax savings each year reduces the cost of your contributions. But you will eventually have to face that tax burden in retirement, which means unless you really need that upfront tax break, it's hard to go wrong with a Roth IRA.

Are IRAs in danger? ›

Federal law protects traditional and Roth IRAs up to a certain limit, which is adjusted for inflation every three years. As of 2023, these IRAs are protected up to a balance of $1,512,350. SEP IRAs, SIMPLE IRAs, and most rollover IRAs are fully protected in the event of bankruptcy, as are 401(k) accounts.

Does an IRA cost money? ›

IRAs are legally allowed to charge annual maintenance fees. Many are $30–$50, while others are as low as $20 or as high as $200 or more. The annual fee may be waived on larger accounts, and some IRAs are set up with no annual maintenance fees.

What are the cons of an IRA account? ›

Disadvantages of an IRA rollover
  • Creditor protection risks. You may have credit and bankruptcy protections by leaving funds in a 401k as protection from creditors vary by state under IRA rules.
  • Loan options are not available. ...
  • Minimum distribution requirements. ...
  • More fees. ...
  • Tax rules on withdrawals.

What are the three types of IRAs and how are they different? ›

Types of IRAs include traditional IRAs, Roth IRAs, SEP IRAs and Simple IRAs. Differences lie in how they're funded and how contributions/withdrawals are taxed.

What is the best type of IRA to have? ›

Retirement experts often recommend the Roth IRA, but it's not always the better option, depending on your financial situation. The traditional IRA is a better choice when you're older or earning more, because you can avoid income taxes at higher rates on today's income.

What are the two types of traditional IRAs? ›

Roth IRA. Contributions are made with after-tax funds and are not tax-deductible, but earnings and withdrawals are tax-free. SEP IRA. Allows an employer, typically a small business or self-employed individual, to make retirement plan contributions into a traditional IRA established in the employee's name.

How are the two types of IRAs different from 401(k)s? ›

While a 401(k) is offered by an employer, an IRA is an account you open on your own. Two common types of IRAs are the traditional IRA and the Roth IRA. The main difference between the two comes down to their tax treatment.

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