Individual Retirement Account (IRA) | Definition
/ˌindəˈvij(ə)wəl rəˈtī(ə)rm(ə)nt əˈkount/An IRA or Individual Retirement account | expense | economy | pension | bitcoin | 401(k) | lender | wealth | return | grant | asset | check | fafsa | will | wage | fdic | bank | loan | bond | fund | spac | debt | loan | atm | definitionsis a retirement savings account. It is another vehicle to help us reach the much sought-after goal of retirement.
Next word Dividend Reinvestment Plan (DRIP) | Definition ᐳ
Unlike 401(k)s, 403(b)s, and pensions, IRAs are not available through your job. Taking advantage of an IRA account is beneficial to ensure you have sufficient retirement income.
An IRA or Individual Retirement Account is a retirement savings account. It is another vehicle to help us reach the much sought-after goal of retirement. Just like other retirement accounts, such as the common 401k or the less common 403b and 457b, the IRA is a place to stash your money with certain tax advantages to grow your money for retirement.
The goal of a retirement account is to make a return or a profit on the money you put in. If invested well, the money in your IRA should grow and grow the longer it stays invested—with ups and downs, of course—until you’re ready to retire.
To meet these goals, we need to understand how the IRA works.
How an IRA Account Works
There are three steps to using an IRA to grow your retirement nest egg.
Opening an account
Most retirement accounts are available through your employer. A 401k can only be opened and operated by an employer, for example. An IRA, on the other hand, is “individual.” That means that you must open it yourself.
Opening an IRA is as simple as going online to a bank or investment firm, looking up an IRA, and opening the account. As a word of caution, the investment options available in an IRA will vary depending on the bank or investment firm you use, so you will need to do your research before opening an account with just anyone.
Recommended Read: What to do if your job doesn't offer a 401(k).
Contribute Regularly
Since an IRA isn’t tied to your employment, the onus to contribute falls on you. That doesn’t mean you have to write a check every month. While you can change your contributions as often as you’d like, the easiest and most dependable way to contribute to your IRA is to set up a recurring deposit from your bank account.
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All IRA providers have a way to automatically contribute every month. The only way to ensure that you don’t get in your own way when it comes to investing is to make it automatic.
Invest Properly
Something that most people don’t realize is that your contributions to an IRA aren’t automatically invested. In fact, you could put money into an IRA your entire life and never invest it once. Your IRA account is like a savings account from which you can invest. That means you need to make investment choices with your IRA provider.
There are a few things to look out for.
- First, you want to minimize risk.
- Second, you want to minimize fees.
- Third, you want to maximize growth.
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I’m not saying you can never break these rules of thumb, in fact, it is a good idea to break them sometimes. But if you’re only invested in something that doesn’t maximize growth, like bonds, for example, then you won’t maximize your retirement. So keep these rules of thumb in mind. There are a few different types of investments that meet these criteria, and some will even adjust risk and growth over time as you get nearer to retirement to protect your investments.
To speak broadly, funds that minimize risk are usually an index. An index spreads your investment across multiple investments in a group called an index. This has the effect of being less risky than individual investments.
Another rule of thumb is fees generally need to be below 1%. The fee of a fund is usually called an expense ratio, but there are often fees just for having an account as well, so it is very important to research the fee structure of the company that you’re investing with. Their representative may even neglect to mention all of the fees. It’s your money, don’t trust anybody else on fees until you’ve verified it.
Maximizing growth is the hardest thing to figure out. Traditional advice is to look at how a fund or index, or investment has done in the past as an indicator of its future. But, past performance is not indicative of future gains, as they say.
That means you can’t trust an investment that has performed well in the past to keep performing well—for example, Sears stock is not growing like it used to. Maximizing your growth cannot be fully addressed here, but remember that a sure way NOT to maximize growth is not investing.
Recommended Read: Investing 101: Real Estate, Stocks and Bonds
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Traditional vs. Roth IRAs
Since the IRA is established by tax codes, it is bound to be confusing. So now we get to tangle with the different kinds of IRA. There are two main kinds of IRAs, the Traditional IRA and the Roth IRA.
The difference between a traditional IRA and a Roth comes down to eligibility, contribution limits, withdrawal rules, tax deductions, tax benefits, and required minimum distributions. To best compare, we’re going to look at a chart.
The Difference | Traditional IRA | Roth IRA |
| Eligibility Requirements | Anyone who has had “taxable compensation” can contribute. Taxable compensation means wages, salaries, commissions, self-employment income, and a few miscellaneous sources of income. | Like the traditional IRA, anyone who had “taxable compensation” can contribute. But not if your modified adjusted gross income is above a certain amount determined yearly. |
| Contribution Limits | The annual limit for 2022, is $6,000, or $7,000 if you’re age 50 or older. This amount changes annually and is totaled between your traditional AND Roth IRAs. | The annual limit for 2022, is $6,000, or $7,000 if you’re age 50 or older. This amount changes from year to year and is totaled between your traditional AND Roth IRAs. |
| Withdrawal Rules | Withdrawals are taxable income, and you pay a 10% penalty if you are under 59 ½. | Withdrawals are not taxable income if done correctly before age 59 ½. Also, withdrawals are not taxable after age 59 ½. There are many exceptions to ask a CPA about. |
| Tax Deduction | The amount that you contribute to your Traditional IRA is deducted from your taxable income, meaning you won’t pay taxes on that income this year. | Roth contributions are made with after-tax dollars, so there is no tax deduction. |
| Tax Benefit | A Traditional IRA is a way to defer taxes. The tax benefit then is that you won’t pay taxes this year, but you will pay taxes when you take distributions in retirement. The best way to remember this is with the Traditional IRA taxes are paid Today. | With a Roth you have already paid taxes on the contributions, so when you take distributions in retirement, you will not pay taxes on them. That means that the investment growth of your ROTH IRA is tax-free growth. The Best way to remember this is with the Roth IRA taxes are paid Right Now. |
| Required Minimum Distributions | At age 72, you are required to start withdrawing money from your Traditional IRA. There are several rules to be followed. | There are no required minimum distributions for the Roth IRA for the account owner. |
Table Source: IRS.gov
Regardless of which IRA you choose, the IRA is a great place to invest for retirement. You can invest in almost anything in your IRA. The most common investment is stocks and bonds, but there are a wide variety of investment options, including mutual funds, ETFs (Exchange Traded Funds), annuities, and real estate.
The Money Wrap-Up
Deciding on an investment vehicle can be confusing. Should you get a 401k or an IRA, or both? Should you invest in a Roth or a Traditional account? With so many options, why should you get an IRA? First, if your job doesn’t offer a retirement savings plan, then the IRA is your only option.
Second, if your job doesn’t offer a match and has high fees on their retirement options, then an IRA is your best option. Third, if you’re maxing out your 401k and you want another place to stash away money for retirement, the IRA is perfect.
What about choosing between a Roth and a Traditional account? That is harder to say, but traditional advice is that a Roth account is for anyone who thinks they will have a higher taxable income in retirement. A Traditional account is for anyone who thinks they will have a lower taxable income in retirement.
Recommended Read: 401(k) vs IRA Which Should I Choose?
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