What is an IRA and How Does it Work?

January 15, 2021

The majority of Americans are concerned about not having enough money for retirement. According to data from the Federal Reserve, the U.S.’s central bank, more than half of U.S. non-retired adults – 64% – either do not believe their retirement savings are on track or aren’t sure. What’s more, a quarter of them – 26% – have no retirement savings whatsoever.1 


Now here’s the good news: If you belong to this group and want to turn your situation around – or simply want to stash more funds away for the future – an IRA offers you a way to help get your savings on track.


What Is an IRA?

An IRA – which stands for Individual Retirement Arrangement– is an account you open at a qualified financial institution that allows you to save for retirement in a tax-advantaged way. Different types of IRA accounts offer different tax advantages. In all types, taxes on growth and earnings are not collected until you withdraw them. That allows the full sum of your earnings to be reinvested, so that your savings grows faster than they would if taxes were taken out every year. The most popular type of IRA also allows you to contribute money before your income tax comes out, allowing you to put more of your dollars to work.


There are two main types of IRAs, each with different advantages:

  • Traditional IRA accounts.
  • Roth accounts.

Advantages of Traditional IRA Accounts

Anyone can contribute to traditional IRAs, which allow many individuals to make contributions with pre-tax dollars – meaning they may be able to deduct what they contribute from the income reported on their tax return. Then, any earnings on these savings will grow on a tax-deferred basis until the account holder retires and withdraws the money. This lets you generate more savings, since the money you would have otherwise paid out to taxes each year continues to generate interest and grow in your account.


Better still, many people enter a lower tax bracket once they retire and stop working. If you do, when you finally withdraw your savings from your IRA you will pay less in taxes than you would have if you paid them when you first earned the money while you were working.


The portion of your contributions that can be deducted from your income taxes changes, however, depending on your income level and whether you or your spouse (if any) are covered by a retirement plan at work.2  Here’s an example: For 2020, you can contribute up to $6,000 and deduct all of it if you are single, are covered by a retirement plan at work, and earn $65,000 or less. If you earn more than $65,000 but less than $75,000 you can deduct a portion of your contribution. If you’re single and earn more than $75,000, none of it is deductible. These thresholds change if you’re not covered by a retirement plan at work, or if you’re married.3 


These figures are subject to change every year. Here are a few other key points to know about traditional IRAs:

  • Withdrawals before the age of 59 1/2 may lead to penalties.            
  • At age 72, you must start taking money out of your IRA in what’s called “required minimum distributions,” or RMDs. Otherwise, again, you may be subject to penalties.
  • You can contribute to an IRA even if your income is above the deductibility threshold – you just won’t get the tax advantage of a current deduction. On the plus side, though, you won’t pay income tax on the nondeductible portion of your IRA when you withdraw money.

Another way to fund your IRA, is through a “rollover”. You can contribute money to a traditional IRA that is "rolled over" from another qualified retirement plan – usually one that was sponsored by a former employer. The advantage of a rollover is that it allows you to consolidate all of your retirement savings from employer-sponsored plans, such as a 401(k) or 403(b), into a single IRA, where it is easier to manage and can continue to accumulate tax free.


Advantages of Roth IRA Accounts

With a Roth IRA, you make contributions with after-tax dollars, but your savings grows tax-free. That means that when you withdraw your money, you get to keep it all. And unlike other types of retirement accounts, with a Roth IRA you’re not required to begin withdrawing a portion of the funds each year at age 72, meaning all of your savings can continue to accumulate tax free for as long as you like. Unlike contributions to a traditional IRA, contributions to a Roth IRA are not tax deductible and you cannot contribute in years your income is above the IRS limit.


Once you open a Roth IRA, you have to wait a minimum of five years before you can withdraw the earnings on your savings tax/penalty free. But unlike a traditional IRA, another advantage to a Roth account is that you can withdraw your original contributions without penalty at any time.


The Bottom Line


As more Americans realize they have fallen behind in retirement savings they have begun stepping up their efforts to catch up. Various types of IRA accounts can help you do this in different ways. By taking advantage of one or more of these tax-advantaged savings accounts, pretty much everyone can grow their nest eggs more rapidly.

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