What is an IRA?
Contrary to what many believe, an IRA is not an investment itself: It’s an investment account you set up at a brokerage firm or other financial institution.
Individuals add money to the account over time and use it to to purchase investments (such as individual stocks, mutual funds and bonds) that are held in the account. Eventually the money in that account can be withdrawn to provide income in retirement.
The main perk of a traditional IRA is that contributions are tax-deductible up to IRS limits, which means contributing to an IRA can reduce your annual tax bill. But there are plenty of other IRA perks:
- In both traditional and Roth IRAs the investments in your IRA grow tax-deferred, meaning you owe nothing on the gains so long as the money remains in the IRA.
- IRAs allow individuals to contribute up to $5,500 per year; that’s on top of what you can sock away in a 401(k) or other employer-sponsored retirement plan.
- Investors 50 and older are allowed to save even more per year — an extra $1,000 a year as a catch-up contribution.
- Although you shouldn’t withdraw money from an IRA before retirement, the IRS does allow individuals to take out money before age 59 ½ to pay for certain expenses.
How to choose the right type of IRA
There are two main types of IRAs: The Roth IRA and the traditional IRA. The primary difference between the two relates to the tax breaks these account offers.
The money you contribute may be deductible from your taxes for the year. A traditional IRA may be a good choice if you think your current tax rate is higher than the tax rate you’ll face in retirement. That way you get the tax break when it benefits you the most.
Contributions are made with post-tax dollars, meaning you can’t deduct them from your taxable income. The payoff of contributing to a Roth is in retirement your withdrawals are not taxed at all. A Roth IRA may be a good choice if you’re in a lower tax bracket now than you’ll likely be in the future.
These aren’t the only differences between these account types, however.
Note that not everyone is eligible for both account types. Eligibility to contribute to a Roth IRA is based on income — only those below a certain threshold are permitted to fully or partially fund an account. Anyone can contribute to a traditional IRA, but the amount you’re allowed to deduct may be limited by your income and whether you or your spouse has access to a retirement plan at work.
How to open an IRA
Before choosing an IRA provider, ask yourself how involved you want to be in the management of your investments:
- If you want to manage investments yourself, an online broker is a good way to go.
- If you want help managing your investments, consider a robo-advisor — an automated and affordable investment manager that selects low-cost and risk-appropriate mutual funds and ETFs.
Once you have chosen a provider, the online signup process for an IRA is pretty simple: Provide some general information (Social Security number, birthday, contact information, employment details). Then choose how you want to fund the account — via bank transfer, perhaps rolling over a 401(k) from a previous employer.