What Is an IRA and How Does it Work?

Saving for retirement is critically important and should be a part of everyone’s financial picture.

But what can you do if you are already maxing out your employer-sponsored retirement plan?

Left behind an old 401(k) when you changed jobs? Or just don’t have access to one?

It’s simple. You can start investing by opening an IRA or Individual Retirement Arrangement—often known as an Individual Retirement Account.

What Is An IRA?

An IRA is a retirement savings account, allowing you to save for your future in a tax-advantaged way.

Your tax savings can be realized in the year funds are contributed to your IRA, or later when withdrawn for your retirement spending.

A quick Google search may leave your head spinning as there are a lot of options—many of which won’t be a good fit for your situation.

Your income, your employment status, your tax filing status, and other factors impact which type of IRA will work best for you.

Most folks will find themselves weighing the pros and cons of the traditional IRA vs. the Roth IRA.

The main distinction between the two is when you want to receive your tax break—at the time of contribution (when you put the money in the account) or at the time of withdrawal/distribution (when you take the money out of the account).

Let’s look at each.

If you’re self-employed, there are options specifically for you.

If you’re a non-employed or low income earning spouse, there’s an option for you, too.

And if you're rolling over an old 401(k) read this.

Unless otherwise noted, the information below is from this IRS publication.

Traditional IRA

Your contributions to a traditional IRA are generally deductible* on your tax returns.

Since you get the tax break up front, when you go to withdraw the money in retirement, you will pay income tax on those funds, including any earnings.

If you’re younger than 59.5 when you withdraw funds, you may have to pay an additional 10% early withdrawal tax penalty, unless you’re able to claim an exemption.

The traditional IRA can be a good option if you expect to be in a lower tax bracket in retirement.

Previously you could not contribute to a traditional IRA if you were over 70.5 years old – that rule has been repealed for tax years beginning after December 31, 2019.

As was the case in 2021, in 2022 you can contribute $6,000 if you’re under age 50, or $7,000 if you're 50+.

Taxable income includes all wages, salaries, tips, commissions, self-employment earnings, and even alimony payments.

There are some income types, such as investment income, or income from rental properties, not included in the definition of taxable income for this purpose. Please check with the IRS for additional rules on taxable income.

*Note: When you or your spouse have access to an employer-sponsored retirement plan AND your modified adjusted gross income (MAGI) exceeds a certain amount, you can be ineligible to deduct the IRA contributions on your tax return. Your IRA then becomes known as a non-deductible IRA. Silver lining: you’ll enjoy the benefit of tax-deferred growth if your investments appreciate.

Required Minimum Distributions (RMDs)

Once you reach age 72 (or 70 ½ if you reached 70 ½ before January 1, 2020), you must take what is known as required minimum distributions (or RMDs).

Essentially, the government is mandating you to begin withdrawing and using these funds.

You must take your first RMD by April 1 of the year after you reach 72 (or age 70 1/2 if you reached 70 1/2 by December 31, 2019).

So, if you turn 72 in June of 2022, your first RMD must occur by April 1st, 2023. After you take the first RMD, you must take one every subsequent year by December 31st.

To figure out how much you must take out, divide your account balance from December 31st of the previous year by your life expectancy (which the IRS defines for you).

If you fail to take RMDs, you can be penalized 50% of what you should have withdrawn from the account.

Roth IRA

You can’t deduct your Roth IRA contributions on your tax returns.

However, you can take distributions (to include contributions and their earnings) tax-free as long as they are qualified distributions.

If a distribution is not qualified, you may be subject to taxation. And, following the traditional IRA rules, unless you’re eligible for an exemption, you may have to pay the additional 10% tax penalty for withdrawals made before age 59.5.

A Roth IRA can be a good choice if you expect to be in a higher tax bracket in retirement or would rather keep all of the funds during retirement.

To contribute, you must have taxable income (defined the same as with the traditional IRA) and have a MAGI that’s under certain thresholds.

If you’re single or filing separately, you can’t contribute to a Roth IRA if your MAGI is $139k or more. If you’re married and filing jointly, the MAGI limit is $206k.

You will be subject to reduced contribution eligibility before you reach these limits. Please see the IRS for more information.

Like the traditional IRA, you can contribute $6,000 in 2022 if you’re under age 50, or $7,000 if you're 50+.

Unlike the traditional IRA, there are no RMDs with a Roth IRA – you may keep the funds in the account for as long as you live.

(Note: If you have Roth funds within a 401k, 403b, or 457b, this is known as a Designated Roth account, and these funds are subject to RMDs.)

You can convert a traditional IRA into a Roth IRA but will have to pay income tax on those funds if you've previously deducted them on your tax returns.

You must put the funds into the Roth IRA within 60 days of withdrawal from the traditional IRA to avoid the 10% early withdrawal tax penalty.

Where These IRAs Overlap

Both types of IRAs can be established through a bank, a stockbroker, a life insurance company, or a mutual fund.

Through them, you may invest in most of the typical investment vehicles, such as stocks, bonds, mutual funds, etc.

There are a few limitations, however, as things like life insurance and collectibles are not considered valid investments within an IRA.

Each type of IRA has the same annual contribution limits. In 2022, you can contribute $6,000 if you’re under age 50. Those aged 50+ can make an additional $1,000 annual catch-up contribution.

While you can have multiple IRA accounts (such as a combination of traditional and Roth), your total contributions across all of the IRA accounts cannot exceed the limit.

For those who are married, total contributions to IRAs cannot exceed double the contribution limit.

You may contribute to either type of IRA until the tax filing deadline for the previous tax year. That means that you can make 2021 IRA contributions until April 15, 2022.

Advanced Tip: Interested in a more hands-on, sophisticated type of IRA? Consider the Self-Directed IRA.

Opening An IRA

You can open an IRA at most financial institutions-often online- including your local banks, credit unions, and mutual fund or brokerage firms big and small.

The significant difference you'll find between various financial institutions is the fees they charge on their IRA accounts.

Be sure you carefully compare fee structures when looking at the numerous institutions before making a selection.

Vanguard and Fidelity are often recommended and both are used by members of the Women Who Money Team.

Your investment options include certificates of deposit (CDs), stocks, bonds, and mutual funds.

A popular choice for most investors is an index fund as it provides low-cost diversification with good long-term returns.

You can fund your IRA in one lump sum or with periodic payments. The most important thing is to start investing – early and often, as much as you can.

Final Words on IRAs

This article is intended to provide a general overview of IRAs, but it does not cover every nuance. Each investor’s situation is a little different, and legislative changes happen regularly.

This information is also presented in terms of you being the original account owner. The account is subject to specific rules if you inherit it.

It’s, therefore, a good idea to speak with a qualified accountant or financial planner before you open, convert, withdraw from, or otherwise modify one of these accounts.

Article written by Laura