What is an Individual Retirement Account (IRA)? And Why You Need One

Investing
Updated: 1st Sep 2021
Written by Kim Pinnelli
Share this article
What Is a Derivative? Definition & Example
What Is an Expense Ratio? Definition
Investing
January 6, 2021
Written by Kim Pinnelli

Disclaimer: This post contains references to products from one or more of our advertisers. We may receive compensation (at no cost to you) when you click on links to those products. Read our Disclaimer Policy for more information.

An Individual Retirement Account (IRAs) is a crucial investment tool that everyone should employ and understand fully.

The earlier you start contributing to an IRA of your own, the sooner you can retire and the bigger nest egg you’ll have to enjoy your golden years.

Keep reading to find out what an IRA is, how to open one, and where.

What is an Individual Retirement Account (IRA)?

In a nutshell, an IRA or individual retirement account is a type of tax-advantaged vessel or investment account that you can use for your retirement savings goals.

Due to the laws surrounding IRAs, you’ll gain tax benefits by putting your money into these accounts instead of keeping them in your personal savings account.

IRAs come in multiple types that provide different advantages or that are designed for different needs.

How Does an Individual Retirement Account Work?

Any money placed into an IRA is used to fund financial products and stock market assets. These include things like:

Since IRAs are accounts designed for retirement wealth growth, investments are made to focus on stability and long-term prosperity rather than risky growth or failure. As a result, the assets held by IRA funds are typically quite stable.

From the account owner’s perspective, they periodically fund their IRA and watch the account’s balance grow exponentially as decades go by.

Of course, people can direct their own IRAs if they have some investment experience. Or they can open IRAs at financial institutions and let the experts there pick and choose the assets invested in with their money.

Depending on the type of IRA you open, you will either avoid paying taxes on initial contributions to the account (which thereby lowers the taxable income you must report to the IRS in a given year) or allows you to avoid paying taxes when you make withdrawals from the account by having you pay taxes on any contributions as you make them.

Over decades, and with regular investments, IRAs typically allow individuals to save hundreds of thousands of dollars by the time they retire.

More aggressive contribution strategies could see individuals saving millions of dollars over their lifetimes. And the earlier you start, the better.

Bonus Insight: The best investing strategy for IRAs is dollar-cost averaging. It is easy to implement, safe and is proven to yield steady returns over the long-term.

Types of IRAs

Let’s break down the major types of IRAs – one by one.

#1. Traditional IRA

A traditional IRA is a basic individual retirement account. With these accounts, you can save for retirement with a minimum of fuss.

These accounts are popular since they are easy to qualify for and relatively easy to understand for those who don’t want to take a super-active part in their retirement growth.

Eligibility

Anyone with “earned income” can contribute to traditional IRAs. So long as you have a job, you can open a traditional IRA. It does not matter how much you make (although you’ll obviously need enough cash left over to make regular contributions).

How it Works

With traditional IRAs, you can deduct the contributions you make to your account each year. How much you can deduct from your contributions depends on your adjusted gross income or AGI. However, you will then need to pay taxes on any withdrawals you make after you retire.

Traditional IRAs require account holders to take required minimum distributions, or RMDs, starting at the age of 72. This means you will have to take money out of your IRA regardless of whether you need the money or not at that point.

Contribution Limits

Individuals can contribute $6000 per year or $7000 per year depending on whether they are younger than 50 or 50 years or older, respectively.

#2. Roth IRA

Roth IRAs are a little more flexible than traditional IRAs. They are preferred by most people since they do not require you to pay any taxes on investment gains.

Eligibility

As with traditional IRAs, you must have earned income. However, you can only contribute to earned income – you can’t contribute, say, $6000 from a $6000 check you got for graduating college from your grandparents. All money contributed to an IRA must be earned from your job.

How it Works

With Roth IRAs, you pay taxes whenever you contribute to your account. This means that only tax-free money gets into the Roth IRA.

When you make a withdrawal, you don’t have to pay any taxes on both the initial contribution amount and any investment gains your account has made over the years.

In this way, it is possible to make more money using a Roth IRA in the long run than a traditional IRA.

Furthermore, you are not required to make withdrawals from a Roth IRA at a set age. You can keep making contributions and growing your wealth (perhaps to pass that wealth onto the next generation) for as long as you live.

Contribution Limits

As with traditional IRAs, Roth IRA contribution limits are $6000 if you are under the age of 50 and $7000 per year if you are 50 and above.

There is an exception if you make lots of cash – for instance, if you make between $125,000 and $140,000 per year, you may only be able to make a reduced contribution to your account.

Learn More: Roth IRA vs Traditional IRA

#3. SIMPLE IRA

SIMPLE (savings incentive match plan for employees) IRAs are ideal choices for self-employed individuals or small businesses. They are remarkably similar to a traditional IRA.

Any business that wishes to offer retirement contributions to its employees can sign up for a SIMPLE IRA.

In a nutshell, SIMPLE IRAs let employees contribute to their IRAs and employers match those contributions or provide a set 2% contribution each time. Each contribution is tax-deductible, but taxes must be applied once wealth is withdrawn from the IRA after retirement.

SIMPLE IRA employee contribution limits are $13,500 per year plus another $3000 per year if a worker is aged 50 or older.

#4. SEP IRA

A SEP (simplified employee pension) IRA is a perfect instrument for freelancers and other self-employed individuals. It’s almost exactly the same as a traditional IRA.

As with a traditional IRA, you must contribute earned income to the account.

A SEP IRA works the same as a traditional IRA. It requires you to make regular contributions for the amount to grow over time. You do not pay taxes on any contributions initially but must pay taxes when you withdraw after retirement.

Furthermore, if a business sets up SEP IRAs for its employees, they can deduct those contributions.

A SEP IRA has contribution limits of either $58,000 or 25% of your combined compensation for your self-employed or freelance/contracting work, whichever ends up being less.

#5. Spousal IRA

A spousal IRA is a unique, shared retirement account that allows a working spouse to contribute on behalf of their partner, who may earn little or no income at all. This circumvents the traditional IRA requirement about “earned income”.

Spouses must file taxes jointly to qualify for and contribute to a spousal IRA. Technically speaking, there is no such thing as a spousal IRA. But an IRA where one spouse contributes on behalf of another counts as a spousal IRA.

Basically, if one spouse does not work or doesn’t earn a lot of money, the spouse who earns more income can contribute twice the individual maximum contribution amount on behalf of their partner.

For instance, the normal limit for yearly contributions is $6000 a year. A spouse who earns $100,000 a year (while his or her partner does not work) can contribute $12,000 per year since the other $6000 is on behalf of their spouse.

As with traditional IRAs, spousal IRAs have contribution limits of $6000 and $7000 per year depending on your age.

#6. Self-Directed IRA

A “self-directed” IRA is any account where the account holder makes the investment decisions instead of relying on a financial institution or robo-advisors. Most self-directed IRAs are either traditional or Roth IRAs.

#7. Backdoor IRA

A backdoor IRA (also called a backdoor Roth IRA) allows people who earn lots of cash to make nondeductible contributions to a traditional IRA.

After making the contributions, the account converts to a Roth IRA. This means the individual circumvents the taxation requirements for both IRA types (since they don’t pay any immediate taxes as with a traditional IRA, nor do they pay any taxes when withdrawing from the eventual Roth IRA).

#8. Inherited IRA

Sometimes, individuals can inherit IRAs from non-spouses. The iris requires anyone who inherits an IRA to start taking RMDs starting December 31st in the year after the original IRA owner’s death, plus each year after. Note that each distribution isn’t subject to the normal 10% early penalty withdrawal.

#9. Rollover IRA

A rollover IRA is a great account to choose if you are transitioning from an employer-backed 401(k) or similar retirement plan. It allows you to keep all of your retirement savings (plus any employer contributions up to that point) and immediately start building wealth in a traditional or Roth IRA.

Benefits of Individual Retirement Accounts

  • You can build retirement wealth without taxes. This allows your potential nest egg to be bigger than it otherwise would be. For instance, any money invested with a traditional IRA is tax-deferred. In contrast, money invested with a Roth IRA is tax-free when you withdraw it.
  • IRAs allow you to compound your initial investment, saving more money than if you just placed your cash in a regular savings account or bank account. The more you contribute, the more exponential your savings eventually become.
  • IRAs help you save more rigidly by preventing you from making withdrawals from the cash. This prevents you from spending the money frivolously and using it before you retire.
  • They make saving easy by adding an automatic bill or contribution to your financial schedule. It’s much easier to regularly and consistently save for retirement when you just add a little bit of cash to your account every month.

How to Open a Roth IRA

You can typically open a Roth IRA at most major financial institutions or organizations, such as Fidelity or Betterment.

Other market brokerages are also good places to look – remember, all IRAs focus on investment with stable financial assets on the stock market.

Many of the best brokerages or financial institutions will use robo-advisors to help you select stocks or assets in which to invest.

Where to Open a Individual Retirement Account

There are lots of great choices for retirement accounts. Here are just a few:

  • Betterment is a financial institution that offers no account fees and a $0 account minimum when opening an IRA. It provides both traditional and Roth IRAs.
  • Vanguard also offers excellent IRA options, but it only provides IRA funds that are high quality (meaning accounts made with this institution are likely to be quite stable).
  • Pick Charles Schwab if you want additional professional guidance, or if you want to set up an IRA for your child if they have already started to earn income.

Bottom Line: What is an Individual Retirement Account?

All in all, individual retirement accounts are important financial vehicles to look into, so you can secure a big enough retirement nest egg for your golden years.

Be sure to think about the above IRA types when choosing which account to apply for and set up. Good luck!

Kim Pinnelli
Kim Pinnelli
Kim is a personal finance expert with a Bachelor’s degree in Finance from the University of Illinois at Chicago. She has been freelance writing for 13 years for a number of large publications. Kim thoroughly enjoys helping people take charge of their personal finances.