What Are IRAs and How Do They Work?

Reading time: 5 minutes

IRAs (or individual retirement accounts) allow you to save money on your own for retirement, whether you are self-employed or just want to supplement any employer benefits package you may have.

Generally, IRAs are subject to the same basic rules as the retirement account options provided by an employer. They have contribution limits and allow you to withdraw money without penalty after age 59 1/2. With the exception of Roth IRAs, withdrawals will be taxable. This is because with traditional IRAs, your money is invested pre-tax and you pay the taxes at withdrawal, but with Roth IRAs, you pay the tax each year as you invest.

There are three fundamental types of IRAs:

1. Traditional IRAs: With these savings vehicles, you can contribute up to a certain annual amount specified by the federal government. For 2020, yearly contributions cap at $6,000 ($7,000 if you’re over age 50), but the exact limit varies each year. You must start withdrawing this money when you turn age 70 1/2. Pre-tax contributions and all earnings the account has accrued are liable to be taxed at the time of withdrawal.
   
   Traditional IRAs are generally used to supplement other retirement vehicles, such as a 401(k) or 403(b) plans you might receive through an employer. You can also set up a traditional IRA for your spouse, known as a spousal IRA.
2. Roth IRAs: The contribution limits are the same as with traditional IRAs, although there is no requirement that you take money out at age 70 1/2. Withdrawals (after age 59 1/2) and investments within the account are tax-free, if held at least five years. There are, however, limits on who can contribute to a Roth IRA, based on income.
3. SEP and SIMPLE IRAs: Two types of IRAs — SEP (simplified employee pension) and SIMPLE (savings incentive match plan for employees) — are available to sole proprietors and small-business owners who have fewer than 100 employees. Eligibility and contribution limits vary depending on your circumstances. Owners can fund the retirement of their employees in this type of plan.

What to know about IRAs

In general, IRAs are simply a shell for retirement investments; in other words, you fill out the paperwork but the actual money management is done by others, such as investment firms or banks.

Unlike 401(k) accounts and most employer-offered retirement plans, you can hold a variety of investments within an IRA, including collectibles, real estate, gems, stamps and coins. Typically, though, IRAs hold stocks, bonds and mutual funds. Virtually every financial service company offers an IRA product.

IRAs are also used as receptacles for lump sums rolled over tax-free from 401(k) accounts. If you will be changing employers or retiring, you can transfer your 401(k) money into a rollover IRA. This will allow you to continue your retirement investing and help you avoid paying taxes on an early withdrawal.

If you already have a retirement plan at work, such as a 401(k), and your employer offers a matching contribution, be sure to contribute enough to qualify for the match. This is like receiving free money. You can then supplement your employer’s plan with an IRA on your own.

Under certain circumstances, you may be able to claim your IRA contributions as a federal tax deduction, but it’s important to pay attention to IRS rules, which vary depending on whether you’re covered by a retirement plan from your employer, your income and your filing status.

The IRS offers a variety of resources that can help you understand IRA requirements, applications, and yearly contribution and deduction limits specific to your financial needs.