What is an IRA and how does it work?

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Individual retirement accounts, or IRAs, are a powerful resource in helping you reach your retirement savings goals. While these tax-advantaged accounts may seem complicated at first, the basics are much easier to understand than you might think.

For many people, retirement planning begins and ends with their employer’s retirement plan, often a 401(k). But 33 percent of private-sector workers don’t have access to an employer-based plan, according to The Pew Charitable Trusts. That leaves many people on their own to save for retirement, and an IRA account is the perfect starting place.

What is an IRA?

An IRA is a type of investment account with tax benefits that can help you save for retirement. You can invest in almost anything using an IRA, so it’s best to think of an IRA like a special “wrapper” that goes around your account and gives it special tax advantages.

“Because of the tax advantages of IRAs, the government is essentially giving you a helping hand – and a powerful incentive – to save for retirement,” says Greg McBride, CFA, chief financial analyst at Bankrate.

There are two basic types of IRAs available to individuals, and one key difference is what kind of tax benefit each gives you:

  1. A traditional IRA offers a tax deduction for the year in which the contribution was made. You make contributions with pre-tax income, so you don’t pay tax on any money you put into the account. It can grow tax-deferred in the account, and when you withdraw it at retirement (age 59 ½ or later), then you pay taxes on the distribution.
  2. A Roth IRA gives investors the chance to invest money after taxes, so there’s no tax break today. The money can grow tax-free in the account, and then you can take the contributions and earnings out tax-free in retirement, too.

How an IRA works

Both traditional IRAs and Roth IRAs have income thresholds that govern who can make qualified contributions to the accounts. In short, if you make too much money, you won’t be able to enjoy the tax break of the traditional IRA, but you’ll always be able to take advantage of the Roth IRA, even if you have to establish a backdoor Roth IRA.

A traditional IRA and Roth IRA differ in other fundamental ways, including when each account is best. The Roth IRA remains a tremendously popular option among investors, largely because of its tax-free feature on earnings. The Roth IRA also offers benefits for estate planning and is more flexible overall, too. Here’s a comparison between the two and why experts love the Roth IRA. 

This Roth IRA calculator can help you see how tax-free returns boost your account quickly.

The annual contribution limit for an IRA is $6,000 for 2020, or $7,000 for savers over 50 years old. You may have any number of IRA accounts, and you can divide your maximum annual contribution between the accounts in any way you see fit.

Is an IRA a good investment?

An IRA can be a fantastic investment, because of the power of its tax advantage. How well your IRA performs depends on the kinds of investments it contains. However, deferring your taxes on any gains (in the traditional IRA) or avoiding taxes on the earnings altogether (in the Roth IRA) is a huge break.

The performance of your IRA beyond that, however, depends on how it’s invested.

With an IRA you can invest in almost any kind of asset – savings accounts, CDs, stocks, bonds mutual funds and even other kinds of assets, if you select a self-directed IRA. What you earn in an IRA is determined by your investments. Lower-risk investments such as CDs and bonds earn a lower return, while higher-risk investments such as stocks can earn a much higher return.

Those with a long time until retirement – think at least five years or more – will probably be best served having a significant allocation to a widely diversified portfolio of stocks. Stocks tend to perform well over time, and the Standard & Poor’s 500 Index, a collection of hundreds of the top companies, has returned about 10 percent annually over long periods of time.

If you opt for a lower-return investment such as CDs or bonds, your returns will likely be lower but the value of your account is likely to fluctuate much less than it would with stocks. You won’t lose money in very safe investments, but you’re not going to knock the lights out either.

But what is clear in every case is that the earlier you start contributing to an IRA, the more money you can potentially make. The exact amount of your returns will vary with market fluctuations, but contributing as soon as you can will give you the benefit of compound interest.

“Time is your greatest ally when saving for retirement. The longer your money is invested, the more you can harness the power of compounding,” McBride says.

For example, if you save $1,000 this year and earn the stock market’s average annual return of 10 percent, you’d have $2,594 in 10 years, but $6,727 in 20 years. Retire in 30 years and you’d have $17,449.

If you’re interested in investing in stocks and don’t know much, an index fund based on the S&P 500 is an attractive option. It provides instant diversification, reducing some of the fluctuations that are typical of stocks, and you’ll own a stake in hundreds of America’s best companies.

By adding money to your IRA regularly, time will increase your returns. Use Bankrate’s compound interest calculator to see how your investments could grow over time.

IRA vs. 401(k)

An IRA and a 401(k) are two different types of retirement accounts. While a 401(k) plan is an employer-sponsored plan that often offers a matched contribution, an IRA can be opened by an individual regardless of whether their employer offers a retirement plan.

Both accounts offer tax benefits, but a 401(k) has a higher contribution limit that caps out at $19,500 per year, as of 2020, or $26,000 for those age 50 and older.

Importantly, you can own and contribute to both account types, and the savviest savers try to max out their accounts each year so that they can get all those tax benefits. For example, many workers max out their 401(k), because they receive matching funds and then top out their IRA.

Here are other key differences between a 401(k) and an IRA.

Who can open an IRA?

Anyone with an earned income can open and contribute to an IRA. That means you need income from a job that is claimed for tax purposes, not investment income or Social Security income, or your spouse must have earned income, so that you get a spousal IRA.

While you’ll need earned income to open and contribute to an IRA, there’s no requirement on taking ownership of an inherited IRA, but it comes with many rules that beneficiaries must know.

How to open an IRA

IRAs can be opened at most financial services providers, online or in person. That includes local banks and credit unions, brokerage firms and big mutual fund superstores or discount brokerages. It’s important to note, however, that some financial institutions will not offer every kind of investment. For example, some banks may not allow you to invest in stocks, whereas online brokers may allow you to invest in CDs, stocks, bonds and other assets.

Though there are advantages and disadvantages to service providers, new savers should look for banks or brokers that make available ample resources, such as online educational materials and in-person guidance. These resources differ from institution to institution, and investors should focus on those that provide a high level of customer service.

For example, Vanguard is one of the biggest and most popular investment firms. There is no monthly fee, but each trade may cost money, depending on what you invest in, though many trades are commission-free.

Another great option is Fidelity, which is well-regarded for its customer service, educational tools and easy-to-use trading platform. The broker also offers no fees for most trades, and it’s great for minimizing other costs, too, making it a perfect fit for beginners.

Need more help? Check out Bankrate’s brokerage reviews to determine which is best for you.

If you’re looking for an adviser who invests for you, a low-cost option known as a robo-adviser may be a good fit. These automated accounts program your investments based on when you need the money and your risk tolerance, and they’re a good fit for those who know little about investing. It’s quick to start with a robo-adviser, and they’re becoming increasingly popular because of how easy it is.

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