Individual retirement account (IRA)

An IRA offers tax advantages on your retirement account. Bankrate explains.

What is an individual retirement account (IRA)?

An individual retirement account, or IRA, is an interest-accruing savings account that lets people save money for retirement while enjoying certain tax advantages. The two main types of IRA, traditional and Roth IRAs, differ on how and when the account holder is taxed, but produce similar rates of return. While some retirement accounts let you withdraw money early, others compel the account holder to wait until a specified retirement age.

Deeper definition

An IRA helps people save for retirement by limiting their tax burden on deposits. The traditional IRA and the Roth IRA are largely similar: each has an annual contribution limit of $5,500 for most of the account holder’s life, and each has roughly the same rate of return. However, they differ in how contributions are taxed, the age at which account holders can withdraw their money without penalty, and whether or not high-income customers can continue depositing money.

With a traditional IRA, the account holder doesn’t pay any taxes on her contributions until she withdraws the money in retirement — contributions are from pre-tax income. Additionally, she can deduct her contributions from her tax returns each year.

On the other hand, contributions to a Roth IRA come out of the account holder’s after-tax income, making Roth IRAs a sounder choice if the account holder is in a lower tax bracket now and expects to be in a higher one when she retires. Roth IRAs also begin phasing out eligibility for people earning above a certain modified adjusted gross income (MAGI): in 2017, the income thresholds start at $118,000 for single people, with a cut-off of $133,000, and $186,000 for married people filing jointly, with a cut-off of $196,000.

Although both retirement accounts limit annual contributions to $5,500, they each allow account holders to contribution an additional $1,000 each year after age 50. It’s also possible to hold both a traditional IRA and a Roth IRA, but account holders are still limited to a combined annual contribution equal to just holding one.

There is a 10 percent tax penalty for withdrawing contributions from an IRA before age 59 ½, but Roth IRAs let account holders withdraw their contributions at any time as long as they don’t withdraw their interest earnings, which they can’t touch for the first five years. The exceptions to this penalty include qualified medical, education, and home-buying expenses.

One form of a traditional IRA is the Savings Incentive Match Plan for Employees (SIMPLE) IRA, which is similar to a 401(k) in that it’s provided by the account holder’s employer but has lower administrative costs. Another variant is the Simplified Employee Pension (SEP) IRA, which is geared toward small-businesses owners who want to set up retirement accounts for their employees.

Have you hit your annual contribution limit but still want to invest? Check out the interest rates on these savings accounts.

Individual retirement account (IRA) example

Maxine is 30 years old with an adjusted gross income of $80,000 and wants to start an individual retirement account. She expects to invest the maximum amount each year, every year, until she retires at age 65, which includes the $1,000 “catch-up” contributions that begin when she’s 50. She decides to go with a Roth IRA. After 35 years, she has contributed $207,500 of her own money, which has grown to $840,412.

More From Bankrate