What is an IRA? How an Individual Retirement Account Can Help You Save for the Future

If you’re hiding your money under your mattress, you’re doing it wrong. 

Financial services can help you grow what you have into something more. But investing toward a comfortable retirement and lasting wealth without exceeding your risk tolerance requires confidence.

If you’re like me, you want to grow your money, and that’s where financial services can help turn today’s mattress cash into tomorrow’s nest egg. One type of financial product that can help is an Individual Retirement Account (IRA). IRAs are investment accounts that offer tax breaks and allow you to grow your money for the future.

An Individual Retirement Account (IRA) is an investment account that provides a tax advantage on money you contribute or earn and put toward retirement.

Some IRAs defer your income taxes while investing your funds in stocks, exchange-traded funds (ETFs), and other assets. While your earnings grow, those tax advantages may bring you the flexibility to hit your stretch goal or enjoy an additional level of comfort or security when you retire.

Understanding the benefits of IRAs means learning about how they fit in the broader investment landscape. I’ll teach you everything I know about IRAs so you can confidently take the money out from under your mattress and put it to work for your future.

All IRAs deliver a tax advantage as an incentive, but the IRS allows for different types and benefits. Keeping the details (not to mention the acronyms) straight can be a challenge.

But viewing IRAs and investing in general as overly complex seems unjustified to me. I think it’s healthier and more productive to appreciate how IRAs and other financial and investment products give you more benefits.

Plus, it’s really not that hard. There are two IRA plans for employees, one for small businesses, and one for self-employed individuals. Because society and the economy constantly change, so do the rules regarding each plan’s qualifications and contribution limits.

“There are two IRA plans for employees, one for small businesses, and one for self-employed individuals.”

You can also have two IRAs going at the same time. I believe it’s a great idea to have both a Traditional and a Roth IRA and make annual contributions to both. You should contribute to the Traditional for any employer match as well as the higher yearly contribution and contribute to the Roth to enjoy the tax-deferred growth. 

Traditional IRA

Along with the Roth IRA, the traditional IRA is one of two IRA plans designed for individuals.

The first point of perspective is that IRAs differ fundamentally from employer-sponsored 401(k) plans. You and your broker or advisor are in charge of your IRA. Your employer has no role.

Think of the traditional IRA as the retirement system’s flagship investment product because it appeals to the most people. All who earn income are eligible to establish one.

Most (but not all) traditional IRA contributions are tax-deductible, rewarding investors with extra income to spend or invest. Holders then pay taxes on their withdrawals after retirement. This plan is great for individuals who plan on being in a lower tax bracket during retirement.

Traditional and Roth IRAs also have maximum contribution limits that may change each year. For example, in 2023, you could only contribute $6,500 ($7,500 if you were 50 or older) total to all of your traditional or Roth IRAs. 

You may also have additional limits on contributions to your Roth IRA, which I’ll detail below.

Roth IRA

Roth IRAs provide additional incentives for long-term savings. While the traditional IRA front-loads its tax advantages, the Roth IRA works in reverse by taxing contributions and allowing tax-free withdrawals after retirement.

That means individuals who expect to be in a higher tax bracket as they approach retirement can keep more of what they withdraw after a lifetime of earning compound interest tax-free.

One thing to watch out for with Roth IRAs is that they may have a lower yearly maximum contribution based on your income. Here is a chart that identifies some of the filing statuses and limits for 2024 based on modified adjusted gross income (AGI):

If you can only contribute a reduced amount, the IRS offers a handy worksheet to help you calculate the maximum. I recommend using the worksheet because the formula can get pretty complicated otherwise. 

SIMPLE IRA

SIMPLE IRAs work differently from traditional and Roth IRAs. While individuals control those plans entirely, small businesses create SIMPLE IRAs to allow employers and employees to contribute to a retirement plan that does not have the high startup and operating costs of a conventional retirement plan.

SIMPLE stands for Savings Incentive Match PLan for Employees, and it is as flexible as it is easy to set up and use. Although small businesses that choose to implement the SIMPLE structure may not offer another retirement savings plan, employees may elect not to participate.

“SIMPLE stands for Savings Incentive Match PLan for Employees, and it is as flexible as it is easy to set up and use.”

Employers may make employee contributions universally or confine their involvement to matching worker contributions. All SIMPLE IRA contributions are tax-deductible.

Simplified Employee Pension (SEP) IRA

The Simplified Employee Pension or SEP IRA works like the SIMPLE IRA in that it allows employers to set up retirement plans for their employees. But businesses of any size, including sole proprietorships, may set up SEP IRAs. And employees aren’t allowed to contribute.

Like SIMPLE IRAs, SEP IRAs are easy to set up and operate. Although employers can contribute up to 25% of an employee’s compensation to a SEP, the structure allows flexibility to compensate for annual variations in revenue and other business needs.

Contributions to SEPs are tax-deductible for employers, and they’re a great option to maximize returns in a low-earning environment.

Congress established IRAs and protects investors through the Employee Retirement Income Security Act of 1974 (ERISA). It administers the IRA system through the Internal Revenue Service (IRS), America’s tax agency.

IRAs are federally regulated financial products designed to be easy to use. Most of what I say in this section deals with traditional and Roth IRAs. The quality or user-friendliness of your experience depends on which provider you choose and the level of control you want to have over your investments.

There are pros and cons to every option. Finding the IRA that’s best for you requires you to acquire ample background information to make an informed decision based on your risk tolerance and financial goals.

Choose a Provider

Many types of financial institutions offer IRAs. They’re all interested in the fee-earning opportunities IRAs afford. IRAs also help financial institutions grow their assets and customer base.

Providers offering IRAs include banks, credit unions, and brokerage firms, which offer them alongside other investment accounts. Mutual funds provide IRAs based on their holdings. Some invest more conservatively as retirement approaches, providing an additional measure of security.

For those less inclined toward risk, insurance companies offer annuities within IRAs that provide guaranteed income streams. Brokerages and financial technology firms may offer robo-advisory services that reduce the need for human interaction in building an investment portfolio.

The more you know, the better. IRAs offer various investment mixes of stocks, EFTs, and other products that appeal to people with risk profiles all over the scale.

Compare fees, costs, expenses, and minimum investment requirements; evaluate customer service and support options according to your needs; and look at the tools and training each platform offers.

Most institutions you’re already familiar with offer IRAs, so your best bet may be to go with someone you know — provided they have the right reputation and a product that fits your requirements.

Make Contributions to Your IRA

The next step is obviously to put money in your account — money you’ve slated to grow through the portfolio you’ve chosen.

The most common way to fund a traditional or Roth IRA is through direct contributions from your bank account. You can choose to do this manually, of course, but the easiest option by far is to set up some form of automatic withdrawal.

Contribute to your IRA directly from your bank account or roll over funds from other investments.

Other strategies may defer taxes beyond those already deferred by the IRA. For example, when you directly roll over funds from another retirement account into your IRA, you can avoid taxes and penalties associated with early withdrawals from the original account.

You could also avoid taxes and penalties by performing an indirect rollover, withdrawing funds from a 401(k), another IRA, or an Employee Stock Ownership Plan, and depositing them manually within 60 days.

Most IRA providers allow direct transfers between IRAs with no penalties. Spouses can contribute to each other’s IRAs provided they meet any additional requirements associated with them. If you’re over 50, you can contribute extra.

You can also convert a traditional IRA to a Roth IRA if you’re willing to pay taxes on the converted amount.

Manage Your IRA Investments

Perhaps the most significant choice you’ll make in choosing an IRA relates to managing your investments. Choose a self-directed IRA if you want maximum control over your portfolio. Choose a managed IRA if you’re inclined to put yourself in expert hands when it comes to investing.

IRAs draw mainly on stocks and ETFs, but products can also include bonds, mutual funds, and so-called alternative investments, including real estate. It’s hard for me to recommend going with self-management unless you’re absolutely confident you can get the results you’re looking for.

That’s because it’s almost too easy to allow professionals to build a portfolio designed to withstand the inevitable bumps in the road while exposing you to a quantifiable risk level.

You also face a decision about human involvement. You may wish to put a human financial advisor in charge of your entire retirement planning strategy and schedule periodic consultations.

Or, you may elect to start an IRA on an easy-to-use robo-advisor platform and then just set it and forget it. Either way, a carefully selected portfolio of diversified assets seems to me to stand a better chance of producing expected gains than putting your eggs in one basket and hoping for the best.

Through ERISA and the IRS, Congress has designed IRAs to incentivize households to invest. Congress did that because it has deemed IRAs a better way to grow additional retirement income for Americans than injecting a higher proportion of public revenue into the Social Security system.

The tax incentives attached to IRAs help more Americans achieve a level of comfort with the idea of risking some of their earnings in the open investment marketplace instead of within the relatively safer confines of Social Security.

Traditional IRAs defer taxes on contributions and tax withdrawals, while Roth IRAs defer taxes on withdrawals and tax contributions.

Differences in the way traditional and Roth IRAs accomplish this allow the system to accommodate investors with different financial statuses and goals.

The takeaway: Get a traditional IRA if you expect your tax bracket to be lower in retirement than during your earning years. Get a Roth IRA if you expect your retirement tax bracket to be higher. Get both if you want to hedge your bets.

Tax-Deferred Growth

The first advantage of traditional IRAs is the income you contribute every year doesn’t get taxed. There are a few exceptions, including situations where a workplace retirement plan such as a 401(k) covers an investor or spouse.

Deductions are also reduced or eliminated for investors above certain income thresholds.

The second advantage is that money continues to grow tax-deferred until you withdraw it. Only then do you pay standard income taxes. You reap the rewards if you’re in a lower bracket in retirement than you were when working.

Tax-Free Withdrawals with Roth IRA

The Roth IRA pays off for those interested in starting as early as possible with slow and steady contributions and for those who expect to be in a higher tax bracket at the end of their earning years than during.

After paying taxes on your contributions, you can withdraw tax-free from a Roth IRA in retirement after watching the earnings compound tax-free for decades.

Required Minimum Distributions (RMDs)

However, investors must begin withdrawing a specified amount, known as a Required Minimum Distribution (RMD), from traditional IRAs starting at age 73. The system calculates RMD amounts based on your account balance and life expectancy.

You’ll pay a penalty of 25% of the amount you should have withdrawn (plus the amount you still owe, of course) if you fail to comply.

Roth IRAs don’t have RMDs during the original account holder’s lifetime, but non-spouse beneficiaries have various RMD obligations.

Congress limits individual contributions in many ways. If it didn’t, the Treasury would probably lose tax revenue due to more contributions to IRAs than the system could handle.

Congress frequently tweaks IRA contribution limits and rules to respond to changing demographics and the changing cost of living or to help it meet fiscal or budgetary goals.

Annual Contribution Limits

As of 2024, you can contribute up to $7,000 annually to your traditional or Roth IRA, and $8,000 for those 50 or older. Those catch-up contributions I referred to earlier mean investors aged 50 or older can put in an additional $1,000 per year.

Again, these maximums may change each year, so stay updated on the latest numbers so you can maximize your contribution.

Income Limits for Roth IRA

You can’t make more than $153,000 if you’re a single tax filer and you want to contribute to your Roth IRA fully. Contributions begin to phase out at that income level, and you can’t contribute to an IRA at all if you make more than $168,000.

For those who are married and filing jointly, those numbers go up to $228,000 for a total contribution and $243,000 to eliminate you from eligibility. Be ready to make whatever contribution you’re eligible to make by the following year’s tax filing deadline.

Penalties for Early Withdrawal

You’ll pay to access your traditional IRA funds early. Traditional IRA withdrawals before age 59½ will cost you a 10% early withdrawal penalty on top of your regular taxes.

You’re in the clear if you withdraw the funds to pay for higher education, a first-time home purchase, medical expenses, or health insurance premiums while unemployed. Those with permanent disabilities are also exempt.

You can withdraw the funds to pay for higher education, a first-time home purchase, medical expenses, or health insurance premiums while unemployed.

Roth IRAs don’t work the same way because you’ve already paid your taxes on your funds. No one will object if you want to withdraw your money early and use it for some other purpose. But you may have to pay taxes and penalties on Roth IRA earnings if you are under 60 years old.

Withdrawing from IRAs should be a last resort. Even without penalties, you lose the investment potential of those funds.

Stories of hiding money in or under mattresses took hold during the Great Depression after widespread bank failures caused many to lose faith in the financial system.

Those days are long gone, but you might as well be hiding your assets if you’re not using them to their fullest potential. Even if you consider investing inherently risky, many IRAs likely fall within your tolerance range.

I’d say it’s worth it. An IRA’s tax advantages can increase your income compared to brokerage accounts with a retirement focus, potentially helping you achieve comfort and security sooner – and with greater peace of mind.