Everything There Is to Know About IRAs

What is an IRA?

Contrary to popular belief, an individual retirement account (IRA) is not an investment in and of itself; rather, it is an investment account that you open with a broker or other financial institution.

Individuals contribute funds to the account over time and use the funds to purchase investments (such as individual stocks, mutual funds, and bonds) held within the account. Eventually, the funds in this account can be withdrawn for retirement income.

IRA benefits

Contributions to a traditional IRA are tax-deductible up to IRS limits, allowing you to reduce your annual tax liability by contributing to an IRA. But there are numerous additional IRA advantages:

• In both traditional and Roth IRAs, your investments grow tax-deferred, meaning that you owe no taxes on the gains as long as the funds remain in the IRA.
• In addition to what you can save in a 401(k) or other employer-sponsored retirement plan, individuals can contribute up to $5,500 annually to an IRA.
• Investors 50 and older are allowed to save even more per year — an extra $1,000 a year as a catch-up contribution.
• Although you should not withdraw funds from an IRA prior to retirement, the IRS permits individuals to withdraw funds prior to age 59 1/2 for certain expenses.

How to choose the right type of IRA

There are two principal types of IRAs: the Roth IRA and the traditional IRA. The primary distinction between the two accounts relates to the tax benefits offered by each.

TRADITIONAL IRA

You may be able to deduct your contributions from your annual taxes. If you believe that your current tax rate is higher than the rate you will face in retirement, a traditional IRA may be a good option. Thus, you will receive the tax break when it will benefit you the most.

ROTH IRA

Donations are made with after-tax dollars, so they cannot be deducted from your taxable income. The benefit of contributing to a Roth account is that withdrawals in retirement are not taxed. If you are in a lower tax bracket now than you are likely to be in the future, a Roth IRA may be a good option.

There are, however, additional distinctions between these account types.

Not everyone is eligible for both types of accounts. The eligibility to contribute to a Roth IRA is based on income; only those below a certain threshold are permitted to fully or partially fund the account. Contributions to a traditional IRA may be limited based on your income and whether you or your spouse have access to an employer-sponsored retirement plan.

How to open an IRA

Before selecting an IRA provider, consider the level of involvement you desire in the management of your investments.

• If you want to manage investments yourself, an online broker is a good way to go.
• If you want help managing your investments, consider a robo-advisor — an automated and affordable investment manager that selects low-cost and risk-appropriate mutual funds and ETFs.

After selecting a provider, opening an IRA online is relatively straightforward. Provide some general information (Social Security number, birthday, contact information, employment details). Then, decide how you would like to fund the account, such as through a bank transfer or by transferring a 401(k) from a previous employer.