What Is an IRA Account and How Does It Work?

IRAs (Individual Retirement Arrangements) are special savings or investment accounts designed to help people save and earn money for retirement. In one form or another, IRAs offer you tax breaks that will help you grow your retirement savings much more rapidly than you could in a standard investment account.

Types

There are two types of IRAs: Traditional and Roth IRAs. The Traditional IRA is an investment or savings account in which the money invested isn’t taxed, and profits on investments are also not taxed, but taxes must be paid on funds withdrawn from the account when you retire. In a Roth IRA, you don’t get a tax deduction on contributions. However, you also don’t pay taxes on money (including profits) withdrawn from the account later on.

Function

Traditional IRAs are primarily for people who are saving for retirement. They are especially attractive if you are in a high tax bracket now but expect to be in a lower tax bracket when you retire. Conversely, investors who expect to be in a higher tax bracket in retirement, such as young people just starting in their careers, gain an advantage by using Roth IRAs. Roth IRAs are also popular as a way to save and invest for specific purposes like college or a home because direct contributions can be withdrawn penalty free at any time instead of waiting for retirement. This, of course, is because the contributions have already been taxed. The lone exception to this rule: Contributions that are "converted" from a Traditional IRA or some other qualified retirement account must remain with a Roth for five years before you can withdraw the money without penalty.

Benefits

For the many people who don’t have a 401(k) plan through their employer, IRAs are a great way to save and invest money. You can also open IRAs in addition to a 401(k) to make additional investments. Anyone who has earned income can open a Traditional IRA, as long as you are under 70 1/2 years of age. Roth IRAs have no age limit restrictions. Even minors can have IRAs as long as they have enough earned income to cover their contributions. IRAs are also flexible in terms of the investment options that are allowed. Investments can be as simple as buying CDs at your bank, or can include a sophisticated portfolio of stocks, bonds, and mutual funds.

Features

Investors can contribute up to a set amount per year to IRAs. In 2012, the limit is $5,000 unless you were 50 or over, in which case the limit rises to $6,000. The contribution limits apply to your total IRA contributions for the year -- if you have more than one IRA account, your combined contributions to all of them cannot exceed the annual limit. It’s easy to set up an IRA and you can do so through your bank, a mutual fund, or a brokerage house. You should read the terms and requirements before you open an IRA account and decide which is best for you.

Considerations

Selecting the kinds of investments you make with an IRA requires careful thought. Investing in CDs at your bank is the simplest and safest investment and sometimes banks charge no fees if you do this. However, the return on your investment is relatively low. The next step up is to invest in mutual funds. These are professionally managed portfolios of securities that you invest in, which typically offer the chance of higher rates of return. However, securities of any kind -- whether they are stocks, bonds or both -- also carry a higher risk of loss than simple bank accounts typically do. Before you invest, check out the mutual fund’s record and read the fund's prospectus carefully to make sure that you understand exactly what types of securities the fund can invest in, and what kinds of risks and potential benefits may be associated with them. A third popular option is to choose your own stocks and other investments. Be sure you learn how the markets work and research any investment thoroughly before you commit your money.

References

• Kiplinger; Open Your First IRA; Cameron Huddleston
• IRS.gov: Publication 590 -- Individual Retirement Arrangements