What is an IRA?

What does an IRA do?

An IRA allows you to invest in a tax-advantaged way specifically designed for retirement.

IRAs can help your overall retirement strategy because what you contribute today could add up over time through compounding—when your investment earnings generate their own earnings. Contributing earlier to your IRA means your money has more time to work for you.  

Benefits of IRAs

Benefits

• Tax advantages. IRAs offer significant tax advantages. The money you save in a traditional IRA may be deductible when contributed, lowering your taxable income for that year and any growth is tax-deferred, meaning it isn’t taxed until it's withdrawn. Roth IRAs offer both tax-free growth and tax-free withdrawals in retirement.¹
• Investment options. IRAs typically offer a wide range of investment options, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs), allowing for personalized investment strategies.
• Compound growth. The potential for compound growth over time can significantly increase retirement savings.
• Potential tax deductions. Contributions to traditional IRAs may help lower your taxes now.
   

Things to consider

• Contribution limits. IRAs have annual contribution limits, which may restrict the amount of money you can save each year compared with other investment accounts.
• Penalties for early withdrawal. Withdrawing funds from an IRA before age 59½ can incur a 10% penalty plus taxes in some cases.
• Required minimum distributions (RMDs). Traditional IRAs require withdrawals to begin at age 73, regardless of whether the money is needed.
• Income limits for Roth contributions. Roth IRAs have income limits, which can prevent high-income earners from contributing directly to a Roth IRA.

Types of IRA accounts

The 2 main types of IRAs are traditional and Roth. Whether you choose a traditional or Roth IRA will depend on eligibility requirements and whether you want to pay taxes on the money now or later. There are also IRAs available that have specific eligibility requirements. More information about the different types of IRAs is provided below.

• Traditional IRAs allow you to take advantage of tax-deferred growth for your retirement investments while lowering your taxable income through tax-deductible contributions.
• Roth IRAs are retirement accounts funded with after-tax dollars. Withdrawals are generally tax- and penalty-free if you meet certain requirements.¹
• Rollover IRAs are designed for you to move your money from a previous employer-sponsored plan. If you're changing jobs, then you might consider rolling your money over into an IRA so you can have more control over the account and access to other investment options than those offered in your old 401(k) plan.
• Spousal IRAs are for couples who are married and filing joint tax returns and allow a spouse who's earning low or no annual wages a way to save tax-efficiently for retirement. A spousal IRA can be either a traditional or Roth IRA and is subject to the same rules as those IRAs.
• Custodial IRAs, also known as minor IRAs, are set up by parents or legal guardians for minors with earned income to help them start saving for retirement early.
• Inherited IRAs, also known as a beneficiary IRAs, are opened when someone inherits retirement fund assets after the death of the original owner.
• SEP IRAs allow small-business owners to fund their retirement in lieu of a 401(k) plan.

Because Roth IRAs are subject to income limits, high-income earners can't contribute to them directly. However, a strategy known as a backdoor Roth IRA provides a workaround that allows them to contribute to a traditional IRA then, convert it to a Roth.

What can you invest in with an IRA?

With an employer plan, you can only invest in the options chosen for you by your employer. But with an IRA, you typically have more investment options to choose from. You'll want to consider your asset allocation, or the way you divide your portfolio among different asset classes like stocks, bonds, and cash. Some of the most common options include:

• Individual stocks. A share of ownership or equity in a company.
• Individual bonds. Loans made from investors to companies or governments, with the promise of repayment over a set period of time along with interest.
• Mutual funds. Pools of money from multiple investors that fund managers use to invest in stocks, bonds, and other securities.
• ETFs. Investments that are built like a mutual fund—investing in potentially hundreds, or sometimes thousands, of individual securities—but trade on an exchange throughout the day like a stock.
• Money market funds. Fixed income funds that invest only in highly liquid, short-term debt.
• Certificates of deposit (CDs). Bank deposits that offer an interest rate for a certain period of time. The issuing bank agrees to return your money on a specific date.

Who should consider an IRA?

IRAs are good for those with earned income who are looking for a versatile and accessible way to save for retirement.

If you're looking to lower your taxable income today, consider investing in a traditional IRA. Your contributions may be deductible in the current tax year, and the money—along with any earnings—won't be taxed until you withdraw it.

When you contribute to a Roth IRA, your contributions aren't tax-deductible, but any growth is tax-free—and you can withdraw it tax-free in retirement if certain rules are met.¹ However, it's important to note that you must fall within Roth IRA income limits to contribute to one.

If you don't have access to an employer-sponsored plan such as a 401(k) or 403(b), you may consider opening an IRA to help you save for retirement. If you already contribute to an employer-sponsored plan, opening an IRA can help you save even more.

Can I borrow from an IRA?

No, you're not able to take loans from an IRA, but you can make withdrawals.

You'll never pay taxes on withdrawals of your Roth IRA contributions. And you won't pay taxes on withdrawals of your earnings as long as you take them after you've reached age 59½ and you've met the 5-year-holding-period requirement.

Withdrawals of your traditional IRA contributions before age 59½ will result in regular income tax on the taxable amount of your withdrawal. In addition, you’ll owe a 10% federal penalty tax—generally on the entire amount—unless you qualify for an exception.

Note that there are qualifying early withdrawal exceptions to the tax penalties for both traditional and Roth IRAs, so it's important to understand IRA withdrawal rules.

If you take an IRA withdrawal but decide you don't need the money, you have 60 days to roll it over to another retirement plan or IRA to avoid paying taxes and penalties. However, you can only do this from an IRA once every 365 days.

Remember that the money in an IRA is meant to fund your retirement, and using it for any other purpose could affect your future retirement savings. So before you make an early withdrawal, you may want to explore other options.

How to open an IRA

1. Find a financial institution that offers IRAs. You can open an IRA on your own through almost any bank, brokerage company, insurance firm, or investment company, like Vanguard.
2. Choose an IRA type. Compare IRA rules and tax benefits to find the best account for you.
3. Transfer money. Move money directly from your bank to your IRA. In most cases, you can do it electronically. You'll just need your bank account and routing numbers (found on your bank checks).
4. Select your investment options. Whether you keep it simple with an "all-in-one" fund that does some of the work for you or customize your own portfolio, there are many different investment options for your IRA. If you're not sure where to start, consider seeking financial advice.

Consider rolling over your old 401(k) into your IRA

If you have money in an old employer-sponsored plan, you may want to initiate a rollover to keep all your money in the same place and have more control over the account.