IRA: What It Is, How It Works And How To Get Started

An individual retirement account (IRA) is a type of tax-advantaged savings vehicle that provides significant benefits for investors, especially with regards to tax-efficient retirement savings. Millions of folks invest in one annually, as it’s often of the fastest and most frequently utilized solutions for growing wealth, especially for retirement.

Here, we take a closer look at how an IRA works and which type of IRA makes the most sense depending on your individual earnings and financial situation. As with any financial decision, consider contacting a licensed financial professional for personalized recommendations.

Key Takeaways:

• An IRA (individual retirement account) is a tax-advantaged investing account.
• You can set up an IRA through a broker or robo-advisor and make contributions straight from your bank account.
• Once you choose your investments, IRAs will earn you money through interest and dividends.

What Is An IRA?

The short answer is that an IRA is a tax-advantaged investment portfolio account. Standard-issue investment accounts are assigned certain rules on how earnings are taxed by the Internal Revenue Service (IRS). On the flip side, tax-advantaged accounts such as an IRA, which are used to save for college tuition, retirement, and other purposes enjoy significant tax breaks and savings.

Utilizing an IRA, for instance, allows everyday investors certain benefits when investing such as the ability to avoid specific tax types and even contribute pretax dollars to the account if desired. This allows investors to have more money over time to invest – and, potentially, enjoy greater earnings and income in later years than if they were investing outside of the tax-advantaged IRA account.

How Does An IRA Work?

As opposed to other retirement savings vehicles such as a 401(k) account (which is employer-sponsored), anyone can open an IRA. That makes the tax-advantaged account a preferred pick for everyday individuals including self-employed working professionals, who may not enjoy access to a 401(k) program. In fact, even if you do have a 401(k), you still have the option to open an IRA to provide added retirement savings opportunities if you like, depending on your income.

Investing in an IRA is often a critical part of any retirement plan, allowing you to supplement Social Security income and other earnings in later stages of life. At the same time, the IRS has rules that govern how you can make tax-free contributions and distributions to and withdrawals from the account. Before diving deeper into how to invest in and operate an IRA though, you’ll want to be aware that there are several types of IRAs (for example, traditional or Roth) that you can use as an investment vehicle as you set about financially preparing for retirement.

Roth Vs. Traditional IRA

There are several different types of IRA available to your average armchair investor. Roth and traditional IRAs are the most commonly utilized types of accounts.

Roth IRA

If you’re wondering what a Roth IRA is, it helps to know that it’s a type of retirement account created in 1997 that is named after Senator William Roth, the primary sponsor of the bill that underwrote it.

Under the terms of the account, as an investor, you can contribute to retirement savings while capitalizing on tax-free growth – but you’ll first pay income tax on any contributions made to your Roth IRA.

A Roth IRA often makes sense for those who suspect that they may be subject to higher tax rates in retirement. That’s because when using a Roth IRA, you’re effectively contributing after-tax dollars and don’t get a tax deduction on these contributions. But when you retire and seek to make withdrawals from the account, these withdrawals can be made on a tax-free basis.

Signing up for a Roth IRA also gives you a little bit more flexibility in terms of taking withdrawals, which often makes a Roth IRA an attractive alternative to registering for a traditional IRA for some investors.

Traditional IRA

A traditional IRA functions differently in that it’s a tax-deductible retirement account. This means that as an investor, you get the benefit of deducting any contributions made to the account on the current year’s taxes, which serves to lower your taxable income and immediate out of pocket costs.

Of course, while you get the benefit of enjoying a tax deduction now when making a contribution, you’ll still have to pay taxes on the money eventually. That means having to make payments on the money to the IRS as you would on any other income once you retire and taking regular distributions from the traditional IRA account. The actual amount that you’ll have to pay in taxes will, naturally, depend on the tax bracket that applies to you or your household at that time.

The tax implications are a big difference between traditional and Roth retirement accounts. Under the terms and provisions of a traditional IRA account, you’ll save tax-free income now and pay taxes later. When using a Roth IRA account, you’ll pay the taxes upfront then receive tax-free income once you’ve reached retirement age. Deciding which makes the most sense for you means considering whether you’ll likely have a higher income (and higher tax burden) now or in retirement. Also be aware that traditional IRAs have rules that apply to when you can withdraw money from the account, and a minimum distribution requirement attached to them.

How To Invest In An IRA

If you’re looking to save for retirement, you’ll want to know how to go about investing in an IRA – and what differences in investing in a Roth vs. traditional IRA might look like.

To open an IRA:

1. First confirm with financial providers that you are eligible to open an IRA account.
2. Determine if you intend to hire a provider to manage account investments or wish to do so yourself.
3. Decide where you’d like to open the account, either in-person or online.
4. Choose the underlying investments that you’d like to hold and fund the account.
5. Determine a regular schedule under which you aim to make contributions to the account.

FAQs About IRAs

Odds are, you probably have additional questions about Roth and traditional IRAs.

What are the contribution limits for IRAs?

Contribution limits on IRAs can change from year to year. But currently in 2024, if you’re under age 50, you can contribute $7,000 to a Roth or traditional IRA account. If you’re over the age of 50, you can make up to an $8,000 contribution.

Are there alternative IRAs?

Yes. If you’re looking for ways to save for retirement, you can also consider alternative options such as SEP IRAs and Simple IRAs. For more information on which makes the most sense for your household’s individual financial situation, consult with a qualified financial advisor.

How do I choose between a Roth IRA and a traditional IRA?

It depends on your individual financial needs and situation. For example, you’ll typically find that a Roth IRA makes better fiscal sense if you anticipate being subject to higher tax rates in retirement. Also, it helps to note that a Roth IRA may provide you with added flexibility in taking out withdrawals from the account should you need access to money sooner.

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

Deciding if you should invest in an IRA or 401(k) often depends on certain factors. For example, do you expect to be taxed at a higher or lower rate during retirement? Does your employer offer a 401(k) match up to a certain percentage? To learn more, speak with a qualified financial advisor and review plan terms.

How much money do I need to have in an IRA?

No minimum is required by the IRS. But individual financial providers may impose one, maybe $1,000 or more in investments. Keep in mind that you can shop around to find a low- or no-minimum fee provider if needed.

The Bottom Line

Among the most common retirement savings vehicles today, an IRA is a form of tax-advantaged investment portfolio account that can provide considerable tax breaks and savings. Allowing you to minimize or defer certain tax burdens, it effectively allows you to increase your nest egg more rapidly, and potentially enjoy greater earnings and income in your retirement years.

While anyone can open and invest in an IRA, which is a standard-issue part of most folks’ retirement plans, don’t forget as well. Specific rules from the IRS determine when and how you can make contributions to and distributions or withdrawals from the account. While several different types of IRAs are available, it’s important to understand these rules before opening one, and understand how such rules and requirements may impact your retirement income.

Interested in keeping better track of your retirement savings? Don’t forget to download the Rocket Money^SM app today!