An Individual Retirement Account, or IRA, is an investment account that allows individuals to save for retirement. Most financial institutions offer IRA accounts, such as banks or credit unions. You can also open an IRA with a mutual fund provider or investment company with the help of a broker.
Learn more about an IRA savings account, how it works, and the benefits of opening an IRA to help you save for the future.
How Does an IRA Work?
Generally, an IRA works by allowing you to contribute funds to an account that grows tax-free until your target retirement date. An IRA isn’t technically one account; instead, an IRA lets you invest your funds into multiple assets, such as bonds, CDs, and stocks, over the life of the account. You can move your funds freely within the IRA and aren’t limited to investment options like you might be with an employer-sponsored 401 (k).
There are two main types of IRAs: traditional and Roth. Each has its benefits and works a little differently from the other.
Traditional IRA Savings Account
A traditional IRA is a retirement savings account that allows you to save money on a pre-tax basis. The money you contribute to your traditional IRA is not subject to income tax and can grow tax-deferred for several years. This means you won’t pay taxes on the earnings until you withdraw the money from your account. Traditional IRA holders are limited to $6,000 contributions per year (or $7,000 for those over 50).
When you do begin withdrawing money from your traditional IRA, you’ll pay taxes on the withdrawals at your current income tax rate. You can start withdrawing money from your traditional IRA at age 59½. If you withdraw money before this, you’ll owe an early withdrawal tax penalty of approximately 10%.
Holders of traditional IRAs must take required minimum distributions (RMDs) when they reach 72 years old. RMDs are minimum annual withdrawal amounts based on the account’s size and the holder’s life expectancy. Failure to make RMDs can result in tax penalties, up to 50% of the amount owed of the undistributed RMD.
Roth IRA Savings Account
A Roth IRA is a retirement savings account that allows you to contribute after-tax earnings. The money you contribute gains interest each year, and you can withdraw the money tax-free in retirement. This approach is advantageous if you’re in a high tax bracket. Like traditional IRAs, you can only contribute up to $6,000 per year (or $7,000 if you’re over 50) to a Roth IRA.
One of the main advantages of a Roth IRA is that you’re not required to take distributions like a traditional IRA. This means that you can accumulate tax-free savings for even longer. Unlike traditional IRA accounts, Roth IRA withdrawals are not subject to income taxes, making them more tax-efficient in retirement.
However, there are some downsides to a Roth IRA. Contributions are not deductible like a traditional IRA, so you’ll have to pay taxes on the money put into your account. The contribution limits each year pose savings obstacles if you’re trying to set aside a large amount of money for retirement. Roth IRAs are subject to the same early withdrawal penalties as traditional IRAs.
How Does an IRA Savings Account Benefit Your Retirement Plans?
Retirees require approximately 80% of their pre-retirement income to maintain a comfortable lifestyle once they finish working. While you may have an employer-sponsored pension plan or 401(k) available, it may not be enough to facilitate your financial goals post-work.
One of the main benefits of an IRA account is that it provides a means to save for retirement in a tax-deferred fund. It can supplement your 401 (k) or other retirement funds, and you can set up automatic transfers from your paychecks to make monthly additions to your account.
Whether you open a traditional or Roth IRA, the tax advantages make them valuable savings options. Although an IRA helps you earn an annual percentage yield, the main focus is on compounding interest in the long term. Tax-free IRA contributions ensure you get maximum use for your earned income, despite not being able to access them until a later date.
Another key benefit of opening an IRA is that the Federal Deposit Insurance Corp. (FDIC) often insures these accounts. This government agency protects your funds if the financial institution where you invested goes under. The FDIC insures accounts for up to $250,000. If you plan to set up an account, opt for an IRA CD (Certificate of Deposit) or an IRA with an FDIC-backed institution.
Start Planning for Retirement with Finance is us
Saving for retirement may seem daunting, but planning for a financially stable future after you retire is necessary. An IRA is one of the safest and most reliable ways to contribute to your retirement fund. With a little planning and discipline, you can ensure that you have the financial security you need in retirement.
At Finance is us, we provide financial advice to help you maximize your earnings for when you stop working. Browse our informational blog for more details on how you can start saving money for your future today.
Disclaimer: All content on this site is information of a general nature and does not address the circumstances of any particular entity or individual, nor is the information a substitute for professional financial advice and services.