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What Is an IRA, and How Does It Work?

The term “IRA” stands for individual retirement account, and its purpose is to help you save for retirement. IRAs are widely available at many financial institutions, and they don’t require the presence of an employer, like a 401(k) does. However, IRAs share many of the tax benefits of a 401(k), and they come in a few different variations: Roth, traditional and IRA CD. Additionally, the IRS sets annual limits on how much you can contribute to an IRA. Along with your personal IRA, a financial advisor in your area can help you build a strong financial plan for reaching retirement.

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 the company. These are called Defined Contribution Plans, and 401(k)s also fit into that category.

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. A Roth IRA works in the opposite way, as you fund this type of IRA with after-tax dollars. So in this case, you won’t pay income taxes even in retirement.

Prior to 2020, the IRS barred anyone who was 70.5 or older from making contributions to a traditional IRA. However, as of 2020, everyone, regardless of their age, can continue funding their IRA.

An IRA distribution is money that you withdraw after you’ve reached 59.5. This age also serves as 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 59.5 a distribution may be confusing, but it helps differentiate between that money and a sum of money you take out early. The latter of these is commonly known as a withdrawal.

How Much Can I Contribute to My IRA?

The federal government places contribution limits on how much money you can put into your IRA, regardless of what kind of account you open. For the 2020 and 2021 tax years, your IRA contributions cannot exceed $6,000 per year. If your taxable income for the year is less than $6,000, then that will be your cap.

To help people who start saving for retirement late, the IRS offers special catch-up contribution limits. More specifically, these exceptions only apply if you’re 50 or older. Once you reach 50, you can contribute an extra $1,000 a year, for a total contribution limit of $7,000.

There are only a few ways you can avoid these contribution limits. One is if the money you’re depositing in your IRA is from a 401(k) rollover. Another is if the deposited funds are from qualified reservist payments.

Breaking Down the Different Types of IRAs

What Is an IRA, and How Does It Work?

While the three main versions of an IRA work essentially the same way, there are some differences between them. This is particularly obvious in what types of tax benefits they provide their owners. The best choice for you will depend entirely on your financial situation, whether or not the money you’re depositing has yet to be taxed and more.

Traditional IRA

A traditional IRA is the most common form of IRA, and it offers many of the same benefits as a standard 401(k). For starters, the money that you deposit in your IRA becomes deductible from your taxable income for the year. In turn, you will hold off paying taxes on those funds. However, there are some rules surrounding the IRA deduction.

Let’s say you have a retirement plan at work. If your tax filing status is single or head of household, then your modified adjusted gross income (MAGI) can be up to $66,000 before your deduction starts shrinking. Once your MAGI reaches $76,000, you’re completely phased out of the deduction.

For those married and filing jointly, their MAGI can be up to $105,000 before their deduction size will begin trailing off. If you file married filing separately, though, you’ll only receive a partial deduction on MAGI up to $10,000.

Once you reach retirement age, the IRS will tax you on the money you withdraw from your traditional IRA. At that time, you’ll pay the normal income tax rate for the bracket your taxable income falls within. If you open a traditional IRA, you will need to start taking required minimum distributions (RMDs) once you turn 70.5 years old. However, if your 70th birthday came after July 1, 2019, RMDs don’t start until age 72.

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 those distributions. This is true regardless of whether you pull from your principal or gains from your investments. Roth IRA account holders are also not subject to RMD rules.

Roth IRAs follow the same contribution limits as traditional IRAs. On the other hand, there are income limits for who can contribute to a Roth IRA. For 2021, single filers and heads of household with up to $125,000 in MAGI can contribute up to the maximum. If you’re married and filing jointly with a MAGI up to $198,000 you can also contribute without restriction.

For those married but filing separately, limits will depend on whether you lived with your spouse during the tax year or not. For anyone who did, they’ll receive a reduced contribution limit if their MAGI is $10,000 or less. If you did not, you can contribute up to the maximum if your MAGI is no higher than $125,000.

If you think your tax bracket is lower now than it will be in retirement, a Roth IRA could be a good option. In addition, 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. There are also no required minimum distributions (RMDs) with a Roth IRA.

IRA CD

An IRA CD is simply a certificate of deposit (CD) that you hold in your IRA. So, instead of investing all of 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 CD that you buy at any bank.

With a CD, you typically earn a low interest rate than you would if your invested in. On the other hand, your money won’t disappear like it could if you invested in stocks. That’s why some people use CDs as a way to keep semi-liquid funds for emergency use, or to hedge against riskier investments.

IRAs vs. 401(k)s

IRAs and 401(k)s are perhaps the two most popular retirement accounts available today. While an IRA is something you open on your own accord, a 401(k) comes to you through an employer. There’s nothing forbidding you from having both accounts at once, though.

One of the biggest benefits a 401(k) has over an IRA is that an employer can match your contributions. This essentially equals a free bonus to what you’re already contributing. Employers often limit how much they’ll match, with caps usually taking the form of a percentage of your salary. For instance, your employer may match up to 3% of your salary’s worth of contributions each year.

Although forever retaining the tax benefits of a retirement account sounds enticing, the IRS will not allow it. This is when RMDs come into play for both traditional IRAs and 401(k)s. But if you open a Roth IRA, you won’t need to adhere to any RMD rules. This is a huge perk, as it means the federal government won’t force your hand in retirement. Note that if you pass on your Roth IRA to a beneficiary, they will need to take RMDs.

When it comes to investments, IRAs typically provide much more plentiful opportunities. That’s because they’re often available directly through brokerages that have a wide range of investments. A 401(k), on the other hand, usually offers a handful of potential investments, with choices revolving around target-date funds. But if you prefer a more hands-off approach, that may not be a big deal to you.

How to Open an IRA

What Is an IRA, and How Does It Work?

If you’re shopping for an IRA, you have plenty of options. Many of the big names in finance offer IRAs and compete with each other to offer more favorable terms. Vanguard is a popular choice for its low fees, but there are other options too.

In the end, it’s important to look for an IRA provider that has low fees. Any charges you incur will eat directly into your retirement savings, leaving you with less money to compound over time.

Once you find an IRA provider whose fees and account terms fit your needs, it’s a pretty simple process. There are a few main steps to opening your own IRA:

  1. Go to your IRA provider’s website or visit a branch location if it offers them. Here, you’ll need to fill out some paperwork and list your name, address, employer, other retirement accounts, Social Security number and more.
  2. Initiate the funding of your account by transferring money from your bank account. You can also roll over a 401(k) into an IRA, but if you do this, make sure to ask your IRA provider for help. An improper 401(k) rollover can leave you on the hook for early withdrawal penalties.
  3. Once your account is open and funded, decide on your portfolio’s asset allocation. This means choosing how much risk you’re willing to take on, and adhering to that plan. For example, a riskier investor might have two-thirds stocks, whereas a safer investor will stick to mostly cash and bonds. Once you make your decisions, you can begin investing.

Opening an IRA CD involves the same steps as opening a savings account at a bank. Simply choose the bank or credit union that you want to open your IRA CD at, pick a term and deposit your money. Note that like a normal CD, the longer the rate you select, the better your APY will usually be.

Bottom Line

Saving money in an IRA can be a great way to set yourself up for a financially secure retirement, while also lowering your tax bill. Of course, when and where your tax benefits lie will depend on the type of IRA account you choose.

IRAs generally offer more flexibility than a 401(k), but they can just as easily coexist. Remember to comply with the IRS’ rules governing IRAs, as contributions are limited, especially if you’re younger than 50.

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Photo credit: ©iStock.com/Drazen Zigic, ©iStock.com/JJ Gouin, ©iStock.com/AscentXmedia

Amelia Josephson Amelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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