Your IRA Explained

What are IRA accounts?

Retirement age may seem far off for some, but while it may be decades away, planning now is the only sure-fire way to ensure you are prepared financially for when that time comes.

This planning is often done with an IRA or individual retirement account.

Sure, you may have a 401k and that is fantastic if you do, but often a 401k is not enough to provide a stable lifestyle for retirees.

An IRA, however, can help to buffer what your 401k will not provide as well as possibly provide some nice tax breaks while you’re building it.

What is an IRA?

As already mentioned, IRA stands for Individual Retirement Account.

This account is an investment account that is used as retirement savings and left alone to build value most often.

Simply having the account can provide certain tax advantages for you both now and later on when it is time to withdraw it.

How to open an IRA

Opening an IRA is easier than you think with this simple step-by-step:

Choose a provider. This could be a bank, a brokerage firm like Fidelity or Vanguard, or an online robo-advisor like Betterment or Wealthfront. Decide what type of IRA you want. A Roth IRA is great if you expect to be in a higher tax bracket later. A Traditional IRA is best if you want to lower your taxes now. Fill out the application. It usually takes just a few minutes. You’ll need your Social Security number, address, employment info, and bank details. Add money to your account. You can do a one-time deposit or set up automatic contributions to make it super easy. Pick your investments. This is how your money grows over time. You can choose from things like mutual funds, ETFs, or stocks, depending on your comfort level with risk.

What Types of IRA Accounts Are Available?

Regular savings accounts typically only have two types; regular and money market accounts, however, there are several types of IRA’s available for use.

These can include traditional IRA’s, Roth IRA’s, SEP IRA or Simple IRA accounts.

While you could simply save for retirement using a traditional savings account, your money will stand a far better chance of growing faster and to higher amounts in an IRA.

This is partially due to tax rules surrounding retirement accounts.

FeatureTraditional IRARoth IRA

Contributions	Tax deductible (if eligible)	Not tax deductible
Withdrawls	Taxable	Tax free (if applicable)
Income Limits	no limit for contributions	Income limits apply
Required Minimum Distributions (RMDs)	Yes at age 73	None during the account holder’s lifetime
Best for	People expecting lower income in retirement	People expecting higher income in retirement

What Tax Rules?

The different types of retirement accounts have different tax rules.

Some may have tax free contributions while others may have tax free withdrawals.

Almost all have penalties if you withdraw the money before the age of 59 ½ however.

What are RMDs?

With a traditional IRA, you’re required to begin taking distributions (called RMDs) starting at age 73. Roth IRAs don’t require RMDs during your lifetime, which can make them great for estate planning too.

As we learn about the different types of IRA accounts, you will learn which account has what tax rules.

There are also maximum contributions to your IRA each year.

These maximums will vary by account type and eligibility for each account as certain types of IRA have income limits that may cause you to be disqualified from using it.

What is a Traditional IRA?

Traditional IRAs are exactly that; the traditional version of the account.

With a traditional IRA, the contribution itself is not taxable meaning it will help to reduce the amount of taxes you pay at the end of the year.

However, the withdrawals are taxable so ultimately you will pay those taxes anyhow.

Traditional IRAs have contribution limits that limit how much money you can add to your account each year. For 2021 the limit is $6,000 per year if you are under the age of 50.

For people over the age for 50, the contribution limit is $7,000 per year.

However, if you or your spouse has a 401k plan through their job, the amount of your max contribution limit in a traditional IRA is reduced and can even be eliminated altogether based on your income.

In these situations, it is best to speak with an accountant or investment advisor to discuss your options.

Scenario:

Jason, Age 40, Full-Time Employee with a 401(k)
Jason works for a large company and already contributes to his 401(k), but he’s looking for more ways to lower his taxable income. He opens a Traditional IRA and contributes $6,500 annually. Because his income is under the IRS limits, his contribution is tax-deductible, which helps him save money at tax time. When he retires, his withdrawals will be taxed, but he expects to be in a lower tax bracket then, so it’s a win.

What is a Roth IRA?

A Roth IRA is one of the more common retirement accounts for those that do not make a large amount of money each year.

For 2021, the contribution limit is the same as with a traditional IRA, however, it only applies to those who meet income limits.

For those who file their taxes as single, their maximum adjusted gross income is $140,000 per year.

For those filing their taxes as married filing jointly, the maximum income is $208,000.

Contributions you make to your Roth IRA are not tax deductible, however, the withdrawals are provided you are over age 59 ½.

You will also not pay taxes on any investment gains in your Roth IRA either provided you meet the age limit for withdrawing.

Scenario:

Emily, Age 26, Entry-Level Job with No 401(k)
Emily just landed her first full-time job. She’s not making a lot yet, but she wants to get a head start on retirement. She opens a Roth IRA and contributes $150/month. Her income is well within the Roth IRA limits, and although she doesn’t get a tax break now, she’ll be able to withdraw everything tax-free later, including all the growth.

How Does Money in an IRA Grow?

Where you open your IRA matters since the investments you are able to use the money in your account will differ depending on the financial institution managing it.

For instance, if you open your account with a bank, you may be limited to investing only in bonds.

If you use a robo advisor, you may be able to invest this money into stocks.

These investments are how your money grows.

As it sits in the account and you build the balance with contributions, your overall balance will grow.

Keep in mind that since you are investing the money, you do also run the risk of losing it as well.

This is especially true if you are investing in stocks.

However, with proper management, you can do everything possible to avoid these losses.

Tips for Beginners

Start early—even small contributions grow over time thanks to compound interest. Set up automatic contributions so you don’t forget. Revisit your investments yearly to make sure they align with your goals. Don’t touch your IRA early unless absolutely necessary—penalties are no fun.

More Real-Life IRA Scenarios

Sometimes the best way to understand how an IRA works is to see how it fits into real life.

Here are a few examples of how different types of IRAs can help people at various stages of life and income levels:

Traditional IRA – Mid-Career Saver Reducing Taxes Now

Meet John, 45, married with two kids.

John earns $85,000 a year and wants to lower his taxable income while saving more for retirement. He already contributes to a 401(k) through work but decides to open a Traditional IRA to boost his savings. His contributions are tax-deductible, which helps reduce his tax bill now. When John retires, he’ll pay taxes on the withdrawals—but by then, he expects to be in a lower tax bracket.

Roth IRA – Young Professional Thinking Long-Term

Meet Emily, 26, just starting her career.

Emily makes $42,000 a year and expects her income to grow in the future. She opens a Roth IRA and sets up a $150 monthly contribution. Her contributions aren’t tax-deductible now, but they’ll grow tax-free—and she won’t owe taxes on her withdrawals in retirement, as long as she follows the rules.

Roth IRA – College Grad Starting Small

Meet Maya, 23, fresh out of college and working her first full-time job.

Maya wants to start investing for retirement but doesn’t have much to spare yet. She opens a Roth IRA and contributes just $50/month. What she loves most is the flexibility—she can withdraw her contributions (but not the earnings) at any time without penalty if she needs to.

SEP IRA – Self-Employed Freelancer

Meet Sarah, 39, a freelance graphic designer.

As someone who works for herself, Sarah doesn’t have a workplace retirement plan. She opens a SEP IRA, which allows her to contribute up to 25% of her net income—much more than a Traditional or Roth IRA. This gives her the chance to save aggressively in good years and cut back when income is lower.

SIMPLE IRA – Small Business Owner

Meet Tom, 52, owner of a small plumbing company.

Tom wants to help both himself and his employees prepare for retirement. He sets up a SIMPLE IRA for his business because it’s easy to manage and has lower administrative costs than a 401(k). It allows both employer and employee contributions, making it a win-win for his team.

Traditional IRA – Nearing Retirement

Meet Linda, 59, planning to retire at 65.

With retirement on the horizon, Linda is making the most of her final working years by contributing the maximum amount to her Traditional IRA, including the $1,000 catch-up contribution for those over 50. This helps reduce her current taxable income while giving her more savings to draw from in retirement.

These examples show that no matter your age, income, or career path, there’s likely an IRA that can fit your needs.

Starting early and choosing the right account for your situation can make a huge difference in your future!

What About the Other Types of Retirement Accounts?

As mentioned earlier, there are several types of retirement accounts available, however, these other types are far less common for families to have than the two mentioned here.

If you have different financial situations such as being self employed, you will want to consider other options such as a SEP IRA.

No matter what your situation is though, having an IRA is a must for anyone who wants to retire some day.