Terms defined: What’s an IRA?
Also, why you should have one
- Typically, you or your spouse need earned income to contribute to an IRA
- Each type of IRA offers tax benefits that reward you for saving
- Both Roth and traditional IRA accounts allow you to save $6,000 to $7,000 per year
While savings accounts are great for the short-term or emergency funds, when you’re saving for retirement, there are much more effective ways to save. This is where an IRA comes into play; think of it as an asset to help you reach your retirement goals.
This guide will define what an IRA is and take a deeper dive into the different types and how to make one work for your retirement.
What is an IRA?
The acronym “IRA” stands for Individual Retirement Account. An IRA is an investment account that is made to help you build your retirement savings. While there are a few different types of IRAs including Roth IRAs, traditional IRAs, self-directed IRAs, SIMPLE IRAs and SEP IRAs, traditional and Roth IRAs are the most popular.
Each different type of IRA offers tax benefits that help reward you for saving. Either you or your spouse will generally need to be earning income in order to contribute to an IRA.
How an IRA works
If you are under 50-years-old you can contribute $6,000 per year to either of the most popular types of IRA accounts, the traditional IRA and the Roth IRA. If you are over 50, you can contribute up to $7,000. You can contribute even if you are also contributing to another workplace savings plan like a 401(k).
Contribution amounts to an IRA account will vary by year. Check out the government retirement plans page to see the new limits each year.
An IRA allows your investments to keep growing tax-free. Depending on the type of IRA, you may be taxed on the withdraws. While most brokers and banks offer traditional and Roth IRA accounts, the investments you will have access to may vary.
With banks, you will usually see investments in the form of certificates of deposit. When you use a broker you can invest in stocks and bonds. Because retirement investing is a long-term play, stocks and bonds are often a good choice because they offer higher returns.
What is the difference between Roth and Traditional IRA?
With a traditional IRA, contributions are tax-deductible. The contributions are only deductible up to IRS limits, however. With a traditional IRA, you won’t owe income taxes until you withdraw the funds. With a Roth IRA, contributions are not tax-deductible. Your investments grow tax-free, however, and you can withdraw money tax-free in retirement from a Roth IRA.
With a traditional IRA, you can usually deduct the amount of your contributions on your tax return each year. This means your money grows tax-deferred and you won’t owe any income taxes until you withdraw the money from your account.
With a traditional account, anyone can contribute regardless of your income. If you or your spouse has access to a retirement plan at work, the amount of your contribution that you’re allowed to deduct from your taxes may be limited by your income.
If you can wait to get your tax break, a Roth IRA may be worth the wait. Contributions are not tax-deductible with a Roth IRA but your money grows tax-free. This means that you never owe taxes on the gains in your investment account. You can also withdraw the money without paying taxes while in retirement.
While in retirement, you aren’t taxed on your Roth withdrawals. This applies to both contributions as well as earnings on your investments. With a Roth IRA, you can also withdraw the money without penalty.
A deeper dive — Related reading from the 101:
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While many people tend to retire at a later age, some choose to leave it all behind early.