An IRA, or Individual Retirement Account, is a type of retirement plan offered by most financial institutions. They are investment tools, which individuals can utilize to set aside and grow funds for retirement. IRAs typically provide significant tax advantages to investors working towards retirement. It is important to understand how you may be able to benefit from having such an account.
There are several different types of IRAs, each with their own set of benefits and restrictions.
A Traditional IRA allows individuals to contribute a portion of their pretax income to the account, up to a specific annual limit. Contributions to your IRA may be tax-deductible, in the year they are made, depending upon your income and other factors. Once deposited into a Traditional IRA, your funds can be invested in securities. All earnings and transactions within the account are then tax deferred, until you reach retirement age. This means that you won’t have to pay tax until the time you withdraw the funds.
Once you reach retirement and begin to receive distributions from your IRA, withdrawals are treated as regular taxable income. However, since income in retirement is typically lower, your tax rate is likely to be lower. Additionally, tax-deductible contributions, made to your IRA before retirement, may allow you to fit into a lower tax bracket during your working years.
Restrictions and limits
IRAs are subject to specific restrictions. Among these is the limit upon how much you can contribute each year. As you get closer to retirement age you may qualify for higher contribution limits to your IRA. Then there are rules regarding how you withdraw funds from the account. The owner of a Traditional IRA is required to begin receiving distributions at age 70 ½. Conversely, withdrawals made before age 59 ½ may be subject to penalty fees.
Other types of IRAs
There are several other types of IRAs, which vary in aspect from a Traditional IRA. Among these are IRAs funded with after-tax contributions, allowing for tax-free withdrawals in retirement. Other IRAs allow small businesses or self-employed individuals to make contributions to the account as an employer, much like a 401(k) plan but with lower contribution limits and lower administration costs.
Which type of IRA is right for you?
IRAs can be valuable tax management tools and should be incorporated into your retirement planning, where appropriate. Your financial advisor can help you assess your personal financial situation and determine which kind of IRA is best for you.