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IRA stands for individual retirement account and that’s exactly what it is—an account that allows you to set aside money for retirement. Whether you’re putting together a new retirement plan or reevaluating the one you’ve got, it pays to consider how IRAs can factor into your overall strategy. Here are a few things to know to get started.

IRAs encourage you to save.

IRAs offer significant tax advantages designed to motivate you to save so you can stretch those retirement dollars. Think of the IRA account as a bucket that can hold different kinds of assets—CDs, savings accounts, stocks, bonds, mutual funds, and more.

Depending on the type of IRA you have, contributions and earnings may be tax-deferred, or earnings may be tax-free. Although all IRAs offer tax benefits, they aren’t a “one-size-fits-all” solution.

Tax benefits differ among IRA types.

The type of IRA that best fits your needs depends on a number of factors, such as your age and income level.

Type of IRA Tax Benefits
Traditional Contributions are pre-tax; distributions are taxed according to your tax rate at the time of the distribution.
Roth Contributions are post-tax; distributions are tax-free after age 59½.
SEP Contributions are pre-tax; distributions are taxed according to your tax rate at the time of the distribution.
SIMPLE Contributions are pre-tax and matched by employers; distributions are taxed according to your tax rate at the time of the distribution.

 
Traditional—With a traditional IRA, you can deduct your contributions (subject to income limits) toward your savings, up to an amount specified by the IRS. Your money is taxed when you take distributions during retirement, which you can begin taking without penalty at age 59½.

Roth—Contributions are made to a Roth IRA after tax, and distributions can be taken tax-free after age 59½. Since you pay taxes on the front end, you don’t have to worry about it later.

SEP—A Simplified Employee Pension (SEP) is an account established by an employer or by someone who is self-employed. Like a traditional IRA, you can take a tax deduction (subject to income limits) and its distributions are taxable. However, the maximum contribution is up to 25% of an employee’s compensation.

SIMPLE—A Savings Incentive Match Plan for Employees (SIMPLE) is a way for employers in small companies to set up IRA retirement plans for their workers. These plans operate a little like a 401(k): Employees can choose to have part of their paycheck go directly into their SIMPLE IRA, reducing their tax burden. Employers can make matching contributions.

Comparing the features of different IRA plans can help you get a feel for which one is fits your situation best. Each type has its own tax advantages and limitations. If you’re like most people, you’ll end up choosing between a Roth and a traditional IRA.

Compare IRAs

You can contribute to your IRA in several ways.

How you contribute to your IRA accounts depends on the assets in the account and how you have the accounts managed.

If you have time on your side or a high risk tolerance, you may choose stocks, bonds, and mutual funds as investment income for your IRA account. These can generate a higher return over time, but carry more risks. You can have a financial professional managing these types of assets in your IRA account; some people use ETFs or robo-advisors, too.

If you’re closer to retirement age or otherwise risk-averse you may consider CDs, money market accounts, or savings accounts as the means for contributing to your IRA. The funds in these savings products in FDIC-member banks are insured up to the maximum allowed by law. With these types of accounts, you may be able to write a monthly check for deposit into the account or have automatic transfers set up to make regular contributions (up to the annual contribution limit).

Contribution amounts are limited by federal law.

A universal truth: you must have earned income to open and contribute to an IRA. The rest of the rules governing federal limits on annual maximum contribution amounts are based on your income, age, IRA type, filing status, and other factors. You can contribute to more than one IRA in the same year, but the total amount can’t exceed that annual limit set by the IRS.

The most common limit guidelines include:

  Roth IRA Traditional IRA
Contribution limits $5,500 age 49 and younger; $6,500 age 50 or older Same as Roth
Income limits Income affects how much you can contribute.  Current limits Income does not affect how much you can contribute.
Age limits Contribute at any age Contribute until age 70½

 

Retirement is the best time to make withdrawals.

Since the point of an IRA is to save for retirement, there are incentives in place to encourage you to leave those funds alone until retirement age.

Although you technically can withdraw your original contributions from a Roth IRA at any age without penalty, there are penalties for withdrawing any associated earnings before age 59½ (or before you’ve had the Roth for five years).

There are also penalties for withdrawing funds from a traditional IRA before you reach age 59½. After that, withdrawals from a traditional IRA are called “normal distributions” and you report those as part of your taxable income.

Before you decide on an IRA account, be sure you understand the ins and outs of making withdrawals—including rules about required minimum distributions (RMDs)—so you can be prepared when the time comes.

Moving funds requires a rollover or a transfer.

You can roll over money from some other retirement plans, like a pension plan or a 401(k), into an IRA without penalty. A rollover may give you more investment options than either leaving the funds in the old 401(k) or putting it into your new employer’s plan. Plus, it stays with you if you change jobs again.

A transfer is simply moving funds from one IRA to another. Transfers can take place as often as you like and are not taxable. Just be sure you handle your IRA rollovers and transfers properly to avoid paying taxes on the disbursement.

You can convert a traditional IRA to a Roth.

If you decide that the tax incentives of a Roth IRA are likely to work better for you than your traditional IRA, you can convert it. However, you will pay taxes on your earnings and on contributions for which you took a tax deduction in prior years.

IRAs don’t have to be complicated—as long as you follow the rules.

An IRA can be a valuable way to save for retirement, but if you’re thinking there are lots of rules, you’re right. It’s important to understand the basics regarding contributions, conversions, distributions, and rollovers, as well as the qualifications for each type of IRA you consider.

It’s a good idea to visit the Internal Revenue Service website for specific, up-to-date information. And always consult a tax professional familiar with your situation before committing to a retirement savings product.

Last Edited: March 6, 2018