What is an IRA? Learn About IRAs And How They Work

What is an IRA? An IRA is an Individual Retirement Account.

I’m glad you’re here because that means you’re serious about investing for retirement as you should be!

It’s never too late to invest but the sooner you do it, the better.

Let’s get right into it.

What is an IRA and how does it work?

What is an IRA? An IRA is an Individual Retirement Account. It’s a type of investment account established by the IRS (Internal Revenue Service) in 1974.

There are different types of IRA accounts. The most common are; Traditional IRAs, Roth IRAs, and SEP IRAs. More on the differences between these accounts below under the heading, “Types of IRAs”.

Money contributed (added) to IRA accounts is invested in financial securities. Financial securities can include; stocks, bonds, mutual funds, ETFs, CDs, etc.

You get to choose the financial securities you invest in. Don’t worry about having to make these decisions on your own. Although I encourage you to do your research, reach out to the professionals for guidance.

Contribution Limits

You can contribute up to a certain amount of money to your account each year. The contribution limit depends on the type of IRA account.

For example, if you have a Traditional IRA, in 2021, you can contribute up to $6,000 each year. More on this below under the heading, “Types of IRAs”.

Always keep an eye out for contribution limits. To see the latest, go to IRS.gov.

Contribution Minimums

There are no contribution minimums.

As long as you don’t contribute more than the limit, you get to chose how much you contribute each year.

Withdrawals

You can start withdrawing money from your IRA account when you turn 59 1/2.

If you withdraw money before you turn 59 1/2, you will be charged a 10% penalty fee.

The goal is to keep your money invested in your IRA account until you retire so the penalty is sort of like an incentive. You wouldn’t want to pay 10% of your balance right?

Think of your contributions as money you won’t see again for another few decades.

Type of IRAs

Traditional IRA

Only earned income can be contributed to this account.

Earned income includes; wages, salary, tips, commission, and self-employed income among others.

It does not include income from; interest and dividends, social security, profit from property or child support.

Money contributed is tax deductible. This means your contribution reduces your taxable income. For example; if you make $50,000/year and contribute $5,000 to your account, instead of having a taxable income of $50,000 it’s $45,000.
You pay taxes on your contributions and capital gains (profit made from investments) until the money is withdrawn.
You can start withdrawing money when you turn 59½.
Regardless of when you withdraw, withdrawals are always taxed. However, if you withdraw before 59½ you’ll be charged a 10% penalty fee.
Can contribute up to $6,000 in one year. If you’re over 50, you can contribute up to $7,000.

ROTH IRA

Only earned income can be contributed to this account.

Earned income includes; wages, salary, tips, commission, and self-employed income among others.

It does not include income from; interest and dividends, social security, profit from property or child support.

If your AGI (Adjusted Gross Income) is over a certain amount, you cannot contribute to a ROTH IRA account.

For example, in 2021, if your filing status is single, your AGI has to be lower than $140,000 in order to contribute. If your filing status is married, you AGI has to be lower than $208,000 in order to contribute.

Money invested in the account is not tax deductible. Your contributions do not reduce your taxable income.
Money contributed is after-tax money. This means you’ve already paid taxes on the money you contribute.
Capital gains (profit from investments) are also not taxed when you withdraw.
You can start withdrawing money when you turn 59½.
You can withdraw money that you invested out of pocket at any time without a penalty fee.
If you withdraw capital gains (profits from securities) before the age of 59½, you will have to pay a 10% penalty fee.
Can contribute up to $6,000 in one year. If you’re over 50, you can contribute up to $7,000.

Traditional IRA vs Roth IRA Summary

SEP IRA

A SEP is a Simplified Employee Pension plan.

Available to people that are self-employed. Contractors, freelancers, and small business owners.
Money contributed is tax deductible.
Can contribute up to $58,000 in one year. Contribution limits are the same regardless of your age.

How To Set Up an IRA

It’s very easy to set up an IRA account. I recently open an IRA account at Vanguard and the process was really simple.

You can set up an IRA account at a:

Brokerage company (Vanguard, Charles Schwab, Fidelity, etc.)
Investment company
Insurance company
Bank

Benefits of IRAs

Tax Advantages

If you’re currently in a high tax bracket, you can really benefit from investing in a Traditional IRA. Contributions to Traditional IRAs are tax deductible which means it reduces your taxable income.

If you’re currently in a low tax bracket, you can really benefit from investing in a Roth IRA. You can benefit from a Roth IRA because you invest after-tax money that’s never going to be taxed again. Wouldn’t you rather pay taxes when you’re in a low tax bracket?

Saving For Retirement

Saving and investing for retirement is essential. It’s important to start thinking about your income during retirement and an IRA can be an additional source of income.

If you already have a 401(k) or 403(b) (other type of retirement investment accounts) you can also have an IRA.

The more money you have set up for retirement, the better.

Worst case scenario, you have to keep working because social security benefits are not enough to live on.

You Have Options

You’ll have options when it comes to investing. You can invest in; stocks, bonds, mutual funds, ETFs, CDs, etc.

If you’re asking, What is a stock? , What is a mutual fund? Click on the hyperlinks to learn more.

Can You Loose Money?

Yes, you can lose money in an IRA. The money you contribute to an IRA account is invested in financial securities that can lose value.

For example; let’s say you invest $6,000 in stock A. Stock A costs $100 and you buy 60, your total would be $6,000. If the price goes down to $80, the value of your investment is now worth $4,800.

Over a long period of time, you can expect the value of your investments to go up. Especially in stocks. Remember to be patient because there will most likely be ups and downs.

What is an IRA Summary