What is an IRA? How they work, types of IRAs and more

An IRA is a tax-advantaged investment account that you can use to save for retirement. Technically, IRA stands for Individual Retirement Arrangement, but the ‘A’ in the acronym is colloquially referred to as an account.

IRAs are particularly valuable tools for the 33 percent of private industry workers in the U.S. who do not have access to a workplace-based retirement plan. Too often, that lack of a 401(k) from an employer means that people don’t save for retirement, but IRAs give all workers a convenient way to prepare for their golden years.

It’s important to note that IRAs can also be ideal for the 67 percent of people who do have access to a workplace-based plan. If you’re maxing out your contributions there or you simply want another option with more control over your investment, an IRA can present a great way to save even more money for retirement.

How does an IRA work?

Using an IRA versus a regular taxable brokerage account for retirement feels similar to the difference between speeding through the E-Z Pass lane on the highway or stopping at the toll booth every 20 miles: You’re going to get where you want to go a bit faster without having to stop at the tax tollbooth every year as you would with a regular brokerage account.

When you open an IRA, you contribute funds that can then be invested in a wide range of assets — CDs, stocks, bonds and other investments. You’re not limited to a menu of investments as you often are in a 401(k). That means you can take full control of picking how this account is invested. If you don’t feel well equipped to direct (in other words, choose investments for) your IRA, it’s wise to browse robo-advisors or pick a target-date retirement fund. Both are low-cost ways to get broad-based diversification tailored to your time horizon and your risk tolerance.

No matter when you’re hoping to retire, today’s asset allocation — how you split your money between stocks, bonds and other investments — is absolutely critical to tomorrow’s earnings. In fact, some studies have shown that asset allocation determines as much as 90 percent of an investor’s total return. IRAs offer flexibility in adjusting those investments, too. You can move in and out of them — for example, shifting your money from individual stocks to bonds — without incurring capital gains taxes.

While you can move the money around freely, you can’t take it out early. An IRA is designed for retirement, which means that withdrawals before you are 59 1/2 will incur both taxes and a hefty penalty of 10 percent — unless you’re using the money for special exceptions such as buying your first home or paying for higher education (and those exceptions come with caveats).

Types of IRAs

IRAs come in two flavors: traditional and Roth. There are two fundamental differences between them: whether you pay taxes before contributing or after withdrawing funds, and when you are required to withdraw funds.

Traditional IRA

With a traditional IRA, you could be eligible to receive a tax deduction in the year you make the contribution (up to a cap on the contribution of $6,000, or $7,000 if you’re 50 or older). When you withdraw the funds later, you’ll pay taxes on the full amount you are withdrawing. Once you turn 72, you must start making withdrawals.

Roth IRA

A Roth IRA doesn’t offer the instant gratification of an immediate tax break. Instead, you’ll pay taxes on your income now, contribute it to a Roth IRA and avoid taxes when you withdraw the proceeds when you retire. However, there is no requirement to make withdrawals from a Roth IRA.

When comparing traditional and Roth IRAs, it’s fairly common to think about current tax status versus your tax status in retirement with the assumption that you’ll be in a lower tax bracket when you are no longer working.

However, I recommend avoiding that debate. Why? Because it’s very difficult to predict your tax bracket 30 years from today. Instead, look at this from the perspective of diversifying your tax exposure and giving that money even more time to grow and compound without the headwind of taxes. Regardless of your future tax bracket, having some assets accumulated in a Roth IRA that can later be withdrawn tax-free is worth considering.

How to open an IRA

To open an IRA, you or your spouse need to have earned income from working. You can open an IRA at a wide range of places including brokerage firms, mutual fund companies, banks and credit unions. Pay attention to management fees, commissions and minimum opening requirements to make sure you find a good deal.

And in addition to the basic terms of each IRA, compare educational resources if you plan on being in the driver’s seat making your own investing decisions. Some firms offer robust tools to help you understand the market and make wise choices.

IRA contribution limits

The government places limits on the amount you can contribute to all your IRA accounts, which change every few years based on inflation. If you’re under age 50, your contributions are capped at $6,000 in 2022. If you’re over 50, your limit increases to $7,000.

Before you think about how to maximize your IRA contributions, though, you need to make sure that your annual earnings fall within the government’s threshold. Your deduction capability begins to phase out as your income increases. The limits vary based on your filing status, so check the IRS’ updated guidelines to verify your eligibility.

Comparing IRA options

The most affordable options for IRAs will be found at no-load mutual fund firms, online brokerages and robo-advisors. Before comparing and deciding where to open an IRA, you should consider which kind of IRA is the best fit for your needs. Keep in mind, too, that the decision between a traditional and Roth IRA is not an all-or-nothing choice. You can have both — you’ll just want to make sure your annual contributions don’t exceed the limits.