What Is an Individual Retirement Account (IRA) and How It Works

As you move forward in your career and start to build toward retirement, you will likely encounter the initials IRA, but just what is this account, how does it work and how do you get started? When used properly and funded regularly, an IRA can be a key component of your retirement planning, and getting a bit of education can help you make the most of it.

The first thing to know is that the initials IRA stand for individual retirement account, and that this a pretty good description of what it is and what it is designed to do. The individual in IRA refers to the fact that you own the account, and the money is yours to invest and move as you see fit. The retirement part of IRA indicates its purpose – the account is designed to help you fund your post-work years.

The account part of the IRA moniker is pretty self explanatory, and you can open that account at a number of different financial institutions. The vast majority of brokerage firms and mutual fund companies offer IRA options, including the chance to open one with very little money. You may even be able to open an IRA at your bank, investing in not only certificates of deposit and savings accounts, but stocks and bonds as well.

You are eligible to open and fund an IRA if you have earned income, including wages from your job. The amount you can put aside in an IRA is updated by the Internal Revenue Service on an annual basis, so you will probably get a chance to put more and more in as the years go by.

Once the IRA is open, you can invest the money in a number of different asset classes. If you open your IRA at a brokerage firm, for instance, you may be able to use that funds to buy individual stocks and various mutual funds. IRA accounts held at mutual fund companies may be invested in a wide universe of funds, and investors can make changes as they see fit.

When you get ready to open your first IRA, you will find that they come in two different forms – traditional and Roth. With a traditional IRA, you get an immediate tax break; the money you put in is subtracted from your taxable income. With a Roth IRA, you forgo that up-front tax break in exchange for tax-free withdrawals in retirement.

The choice of traditional vs. Roth IRA can be a complicated one, and making that decision will always involve some level of uncertainty and even guesswork. If you think that tax rates will be higher in the future, you might opt for a Roth IRA, tempted by the idea of tax-free withdrawals down the line. If you are currently in a high tax bracket, the up-front savings a traditional IRA provides may be even more tempting.

Whether you choose a traditional or Roth IRA, there are rules governing how and when you can take the money out. As with the annual contribution limits, these rules are subject to change, so it is always a good idea to talk to an experienced tax preparer before taking any withdrawals. Keep in mind that the original purpose of the IRA was to make saving for retirement easier, and taking money out prematurely could put those retirement plans at risk.

Opening and funding an IRA is one of the best ways to maximize your retirement savings while keeping your taxes under control. Whether you opt for the up-front tax savings of a traditional IRA or the long-term tax-free treatment of a Roth IRA, you can put money aside now, give it time to grow and enjoy the fruits of your hard work when your career is over.