What Is an IRA & How Does It Work?

What does “IRA” stand for?

IRA stands for “individual retirement account” and that’s exactly what it is — an account that allows you to set aside money for your retirement. Whether you’re putting together a new retirement plan or reevaluating the plan you already have, it pays to consider how the right IRA can factor into your long-term strategy.

What is an IRA?

An IRA is a retirement account set up at a financial institution that allows you to save money on a tax-deferred basis or by utilizing tax-free growth. There are several different types of IRAs you can invest in (which we’ll get into later), and they differ depending on your preferences, income tax situation and employment situation.

Benefits of an IRA

Why might you want to invest in an IRA, besides the fact that it could set you up for retirement? Let’s take a look at a few benefits of an IRA:

• IRAs encourage you to save: IRAs are designed to motivate you to save, so you can stretch those retirement dollars. Many brokerage accounts offer creative ways to entice customers and encourage them to save money in their accounts.
• Wide variety of options: Think of the IRA account as a bucket that can hold different kinds of assets — certificates of deposit (CDs), savings accounts, stocks, bonds, mutual funds and more. Think big! If you want to invest or save in a wide variety of ways, an IRA gives you that opportunity.
• Tax advantages: There are tax benefits of IRAs, depending on the type of IRA you have — contributions and earnings may be tax-deferred, and earnings may be tax-free. Although all IRAs offer some tax benefits, they aren’t a “one-size-fits-all” solution. You may want to check on the capital gains tax rate and how it applies to you. Consult with a tax professional when considering your own situation, so you get a full picture understanding.
• Many investment time horizon options: “Investment time horizon” means that you can choose investments based on your time horizon. If you won’t retire for a number of years, you may want to invest in stocks, bonds and mutual funds, which can generate a higher return over time but carry more risks compared to other investment products. If you’re closer to retirement age or otherwise risk-averse, you may consider “less risky” CDs, money market accounts or savings accounts instead. The funds in these savings products in FDIC-member banks are insured up to the maximum allowed by law.
• Many choices for how to invest: A financial professional may manage the assets in your IRA account or you may want to use a robo advisor for a more DIY approach.

The different types of IRAs and their tax benefits

We’ll break down a few different types of IRAs and some of their tax benefits, from traditional and Roth to SEP and SIMPLE IRAs in the table below.

• Traditional IRA: With a traditional IRA, you can deduct your contributions (subject to income limits) toward your savings, up to an amount specified by the Internal Revenue Service (IRS). Your money is taxed when you take distributions, which you can begin taking without penalty at age 59½.
• Roth IRA: 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. If your tax rate will be higher after age 59½, making Roth contributions now could make sense, while the reverse is true with a traditional IRA.
• SEP IRA: A Simplified Employee Pension (SEP) IRA 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 distributions are taxable. The maximum contribution is up to 25% of an employee’s compensation.
• SIMPLE IRA: A Savings Incentive Match Plan for Employees (SIMPLE) IRA 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, potentially reducing their tax burden. Employers can make matching contributions.

Comparing different IRA plans can help you get a feel for which type of IRA best fits your situation. Each type has its own tax advantages and limitations. Many people end up choosing between a Roth and a traditional IRA.

Compare Ally Bank IRAs

What are the IRA contribution limits?

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, otherwise known as IRA contribution limits.

The most common limit guidelines include:

How to contribute to your IRA

Funding an IRA doesn’t have to be complicated. You can contribute to your IRA in several ways, and the easiest is through a payroll deduction from your paycheck if your IRA investment is through an employer-sponsored retirement plan. Your employer will forward the payroll deduction to your IRA account at the company’s affiliated financial institution.

Set up your IRA paperwork so that money goes into your IRA with every paycheck, however often you receive one. To really work toward your IRAs full potential, invest a percentage of your paycheck, so if you receive a raise, your retirement investment will also increase.

If you don’t work for a traditional employer, are self-employed or want to open another account on top of your employer’s IRA offerings, you can open an account on your own through a robo advisor or a financial advisor. Set up your money to go into your investment accounts automatically, just like you would if you had set up your IRA through an employer.

When can I withdraw from an IRA?

Withdrawing from IRAs before age 59½ generally means you must pay a 10% early withdrawal penalty.

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 account 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 IRA withdrawals. Also be sure you know the answer to the question, “What is the required minimum distribution?” (also called RMDs) — so you can be prepared when the time comes.

Moving funds requires a rollover or a transfer

When you decide to move funds, which commonly happens when you change jobs, you may consider a transfer or a rollover. The difference between the two concerns the type of account you’re moving. In a transfer, you move an IRA to another IRA directly. A rollover usually means you’re moving an employer-sponsored plan to an IRA, which can be a direct or indirect move. For example, you might move money from a 401(k) into a traditional IRA.

Read more: IRA vs. 401(k) — Making the Most of Your Retirement Savings

You can roll over money from some other retirement plans, like a pension plan or a 401(k), into an IRA without penalty. You can roll over the payment in another retirement plan or IRA within 60 days. Your financial institution or plan can also directly transfer the payment to another plan or IRA, as long as you file the paperwork.

A rollover may give you more investment options than simply 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.

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 Roth IRA contributions are likely to work better for you than your traditional IRA, you can undergo a Roth IRA conversion. 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. (Did you know you can even receive an inherited IRA?) 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. Always consult a tax professional familiar about your specific situation as you consider different retirement savings accounts.

If you have earned income you want to invest, consider giving your retirement savings a boost.

Check out Ally Invest IRAs