IRA

IRA summary:

• An IRA is a retirement plan you open on your own to save for retirement.

• The tax breaks you get with an IRA could make it easier to save for the future.

• IRAs have rules you need to follow to avoid penalties.

IRA definition and meaning

An IRA, or individual retirement account, is a retirement plan you open and manage on your own through a bank or financial institution. The money in your IRA can be invested so it increases over time. While IRAs offer savers different tax breaks, they come with strict rules for withdrawals. 

Key concept: An individual retirement account lets savers contribute set amounts of money each year for their someday retirement.

More on IRA 

IRAs come in two types, traditional and Roth. Here’s how they differ:

• Traditional. You contribute money pre-tax, and pay tax when you withdraw the money in retirement. The gains are tax-deferred, which means you're taxed on your gains at the time you take withdrawals. You can’t withdraw the money without paying a penalty before age 59 1/2. Traditional IRAs have required minimum distributions once you’re 73.

• Roth. Your contributions are made after-tax, but the money you withdraw is tax-free. Gains on investments are also tax-free. Roth 401(k)s don’t come with required minimum distributions. Your contributions are always available to withdraw, tax-free and penalty-free, because you’ve already paid tax on that money. However, you can't take out the earnings before you're 59 1/2. The five-year rule says you must have had the account for at least five years to take it tax-free and without penalty.

There are also other types of IRAs for people who are self-employed or own a small business that have their own rules and contribution limits.

Pro tip: Not everyone can contribute to an IRA or take the full tax deduction if they do. You’ll start hitting limits as your income rises.  

IRA: a comprehensive breakdown

Here are some common features of an IRA.

Earned income 

You don’t need to be a salaried employee to contribute to an IRA, and these accounts can be useful to people who are self-employed. To contribute to an IRA, you need to have earned income. For example, if you put $2,000 into an IRA in a year, you need to have made at least $2,000 to be able to do so.

Spousal IRA

A non-working spouse can have their own IRA—traditional or Roth—even though they have no earned income. Here’s how that works. A working spouse can contribute to their spouse's IRA up to the annual limits. That means a household with just one earner can save for both spouses' retirements. Married couples must file a joint tax return, and the combined IRA contributions can't exceed the working spouse's earned income. The spousal IRA is held in the non-working spouse's name and is subject to the same contribution limits and rules as any other IRA.

Contribution limits

The IRS sets annual contributions limits for IRAs that can change but sometimes remain the same for a couple of years. The increase is generally $500 or $1,000 if the IRS raises the limit. People 50 and over can make catch-up contributions to their IRA, typically an additional $1,000 per year. 

Tax benefits 

An IRA either gives you a tax break on your contributions or your withdrawals, depending on the type of IRA you open. If the investments in your IRA earn money, you’re not taxed on those gains every year. Instead, you pay taxes on gains when you take withdrawals from a traditional IRA. If you have a Roth IRA, your investment gains aren’t taxable.

Investment choices

IRAs allow you to invest your money so it can increase over time. Some common IRA investment choices include:

• Individual stocks

• Exchange-traded funds (ETFs)

• Mutual funds

• Index funds

• Money market funds

Withdrawal rules

Because IRAs come with tax breaks, there are withdrawal rules to follow. You'll be hit with a 10% early withdrawal penalty for taking an IRA distribution before turning 59 1/2, though there are some exceptions for disability and other situations. 

A traditional IRA means you'll have to take required minimum distributions starting at age 73 or later, depending on the year you were born. If you don't take those required distributions, you risk having to pay a penalty.

If you’re interested in learning more about IRAs, talk to a registered investment advisor, your employer’s plan administrator, or the help desk at an investment house like Fidelity or Vanguard.