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What Is an IRA?

IRA stands for “Individual Retirement Account.” The name says it all. An IRA is an account you open on your own – you don’t need the participation of your employer to open an IRA. If you’re curious about how IRAs work and how to start one, you’ve come to the right place. We’ll walk you through what you need to know about this powerful retirement savings tool.

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What Is an IRA?

The history of the traditional IRA begins in 1975, when the provisions of the 1974 Employee Retirement Income Security Act (ERISA) came into effect. That opened the door for the Individual Retirement Account, through which Americans could start saving for retirement if they didn’t have a pension they could count on.

As the years passed, pensions became less and less common. In their place rose retirement plans that put the burden of savings on the worker rather than on the company. These are called Defined Contribution Plans (think IRAs and 401(k)s).

How Does an IRA Work?

With a traditional IRA, you can contribute money from your pre-tax earnings to an account that will grow over time. Each year at tax time, you can deduct some or all of the amount that you contributed from your income, lessening your tax burden. When you start taking distributions from your IRA in retirement, those distributions will be taxed as income.

An IRA distribution is money that you withdraw after you’ve reached 59 1/2 (the cut-off for being able to dip into your IRA without incurring a penalty). Calling the money you take from your IRA after age 59 1/2 a distribution may be confusing and jargon-y, but it helps differentiate between that money and a sum of money you take out early (which is known as a withdrawal).

IRA Contribution Limits (Maximum IRA Contributions)

For 2015, your total contribution to all of your traditional and Roth IRAs can’t exceed $5,500 (or $6,500 if you’re 50+). Your IRA contribution also can’t be greater than your taxable compensation for the year if that was less than $5,500 (or $6,500 if you’re 50 or older). The IRA contribution limit doesn’t apply to rollover contributions, these would be funds from a 401(k) at a previous job that you are adding to your IRA.

IRA Tax Deduction

As mentioned above, contributions to your IRA are tax deductible. If neither you nor your spouse (if you have one) has a retirement plan at work, the full amount of your IRA contributions is tax deductible. If you or your spouse saves through a retirement plan at work, your deduction may be limited, particularly if you are high earners. This IRS chart explains the deduction rules (by filing status and income) for taxpayers who are covered in retirement plans at work. There’s also a chart with the deduction rules for those who aren’t covered through work.

How to Open an IRA

IRA shoppers have plenty of options. Many of the big names in finance offer IRAs and compete with each other to offer favorable terms. Vanguard is a popular choice for its low fees, but there are other options too. It’s important that you look for an IRA provider offering low fees. Fees eat into your retirement savings, leaving you with less money to compound over time. Want to give tens of thousands of dollars to a financial institution if you don’t have to? Nope, we didn’t think so.

Once you find an IRA provider whose fees are reasonable, it’s a pretty simple process. There are three steps, though different providers may take the steps in a different order.

1) Open an account with your provider of choice. This generally means filling out a form and signing it. Easy enough, right?

2) Decide on your asset allocation. This means choosing how much risk you are willing to take on. If a higher percentage of your IRA is in stocks, you’ll carry more risk but have greater possibility of return. If you don’t want to make investment decisions and rebalance your allocation over time, consider a Target Date Fund. You can enter your desired retirement date and your IRA provider will balance your funds accordingly.

Related Article: The Pros and Cons of Target Date Funds for Retirement

3) Fund the account by transferring money from your paycheck or bank account to your new IRA. You can also roll over a 401(k) into an IRA. If you do this, make sure to ask your IRA provider for some help. An improper rollover from a 401(k) to an IRA can leave you on the hook for early withdrawal penalties.

What Is a Roth IRA?

Unlike a traditional IRA, a Roth IRA lets you save with after-tax dollars. That means you won’t reduce your taxable income now, but you’ll get tax benefits down the road. When you withdraw money from a Roth IRA in retirement, you don’t have to pay taxes on that money. If you think your tax bracket is lower now than it will be in retirement, a Roth IRA could be a good option. Here’s another important point about the Roth IRA: the younger you are, the more you stand to gain from opening a Roth, since you’ll accrue more tax-free earnings on your contributions.

Related Article: Which Type of IRA Is Right for You?

What Is an IRA CD?

An IRA CD is simply a certificate of deposit (CD) that you hold in your IRA. So, instead of investing all your IRA funds in stocks and bonds, you buy one or more CDs. The pros and cons of an IRA CD are the same as those of a regular old CD that you buy at a bank.

With a CD, you earn a low interest rate (very low, these days) that won’t grow your money by any substantial amount. On the other hand, your money won’t disappear like it could if you invested it in stocks. That’s why some people use CDs as a way to keep semi-liquid funds for emergency use, or to hedge against more risky investments. CDs are for people with very low risk tolerance, or who have so much money that they don’t need to take their chances on stocks in order to chase returns on their investment. Which is to say that basing your entire IRA on CDs won’t get you very far.

 Bottom Line

Saving money in a traditional IRA can be a great way to set yourself up for a financially secure retirement while also lowering your current tax bill. Just remember to comply with IRS rules governing IRAs, and don’t forget that you’ll owe taxes when you withdraw money from your IRA in retirement. Now start saving!

Photo credit: flickr

Amelia Josephson Amelia Josephson is a staff writer covering financial literacy topics at SmartAsset. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.

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