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What Is an individual retirement account (IRA)?

Learn how individual retirement accounts work

Profile picture of Kathryn Parkman
by Kathryn Parkman ConsumerAffairs Research Team

Gold and other precious metal IRAs are an investment and carry risk. Consumers should be alert to claims that customers can make a lot of money in these or any investment with little risk. As with any investment, you can lose money, and past performance is not a guarantee of future performance results. Consumers should also obtain a clear understanding of the fees associated with any investment before agreeing to invest.

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Key takeaways:

What is an IRA?

An IRA, or individual retirement account, is a tax-advantaged way to save for life after your career. Depending on the type of account you open, an IRA lets you make tax-free contributions before retirement or withdraw funds after retirement without any new taxes.

Similar to a 401(k), an IRA is a special type of investment account that lets you grow savings while enjoying certain tax advantages. IRAs are common investments for those who don’t have retirement options through their employers, but almost anyone can open one.

As of 2021, IRA limits are $6,000 or $7,000 per year, while the traditional 401(k) limit is $19,500.

IRA programs are designed to encourage people to save more for retirement. Basically, the U.S. government gives you a tax break for having a retirement savings plan. It works a little like when you get a deduction for donating to charity — except you’re donating to your future life. Because IRAs are sheltered from certain taxes, they incentivize you to save as much as you can. Traditional IRAs were introduced in 1974 when Congress passed the Employee Retirement Income Security Act (ERISA), and then Roth IRAs became an option after the Taxpayer Relief Act of 1997.

Differences between 401(k)s and IRAs

The main difference is that an IRA is an “individual” retirement account that doesn’t necessarily involve your employer, while a 401(k) is offered through your employer, much like a pension plan. Otherwise, 401(k) retirement plans work like traditional IRAs.

401(k)s do generally have higher contribution limits, but they’re more limited in terms of investment opportunities, especially if your company offers just a few index fund options. IRAs are often opened by individuals either in addition to their 401(k)s or because they don’t have options for 401(k)s through their employers.

Types of individual retirement accounts

Being an IRA owner helps you make the most of your investments in stocks, bonds, real estate and even precious metals. However, different types of IRAs have different tax advantages and requirements. Your age, income and financial goals will largely determine which type of IRA is right for you.

Traditional, self-directed and Roth IRA programs are designed to help almost anyone save for retirement. SEP and SIMPLE IRA plans are generally for freelancers and small-business owners. We’ve outlined the types of IRAs below to help you see which works for your retirement strategy.

  • Traditional IRA: A traditional IRA lets you save money with tax-free growth on a tax-deferred basis. As of 2021, you can save up to $6,000 per year with a traditional IRA until you turn 50, then $7,000 per year until you turn 70. You contribute pre-tax funds and earn interest on the account, and then taxes are due when you retire and start to withdraw funds. In other words, this type of IRA front-loads all the tax benefits.
  • Roth IRA: Roth IRAs are similar to traditional IRAs, except Roth IRA contributions aren’t tax-deductible, meaning you pay taxes when you cash out in retirement. So, contributions to a Roth IRA don’t have an immediate tax benefit. Instead, you save money down the road when it comes time to take out money for retirement. They are increasingly popular with millennials who expect taxes to increase before they retire.
  • Self-directed IRA: With a self-directed IRA (SDIRA), you can choose from a variety of investments not available through traditional IRAs. For example, a gold IRA holds investments in physical bars and coins. Self-directed IRAs can also be used to invest in other precious metals, such as silver, platinum and palladium. The investment is held in a bank or other trusted vault. Although cryptocurrencies aren’t a physical asset like gold, a Bitcoin IRA can offer similar flexibility.
  • SEP IRA: Freelancers, contractors and small-business owners can take advantage of a Simplified Employee Pension (SEP) IRA. A SEP plan is a work-sponsored retirement plan that helps employees with retirement savings. With a SEP plan, businesses usually offer some contributions. SEP IRAs are generally beneficial to small businesses because they come with additional benefits like a low-cost startup and straightforward paperwork. SEP plans are generally cheaper and easier to keep up with than related Keogh plans. However, SEP contribution limits are often lower.
  • SIMPLE IRA: A SIMPLE IRA plan, or Savings Incentive Match Plan for Employees, lets employees and their employers contribute to retirement savings through traditional IRAs. The main difference between a SIMPLE IRA and a traditional IRA is that a SIMPLE plan is offered by a business. Unlike a 401(k), though, SIMPLE plans are offered only by small enterprises with 100 or fewer employees.

How does an IRA work?

Instead of thinking of an IRA as the actual investment, think of it as a special vault for your investments. You usually have to pay taxes when you make money on an investment — such as capital gains taxes — but not when you're an IRA owner. The downside is that, if you access the funds before you turn 59 ½, you have to pay taxes plus penalties (with a few exceptions).

Traditional IRA owners make tax-deductible and tax-deferred contributions, usually on a biweekly basis, into the account. This means the money isn’t taxed every year as it would be in a bank account — and what you save can help lower your tax bracket. As long as you meet certain income and filing criteria, the amount you put into a traditional IRA is deductible from your income taxes.

IRAs do have contribution limits, though. Until you reach age 50, you can put up to $6,000 into all of your IRAs per year. After 50, the limit increases to $7,000. IRA regulations apply these limits to help prevent higher earners from benefiting more from IRA tax advantages. Usually, IRA rollovers and transfers from other accounts don’t count toward that limit. According to IRS guidelines, there's no longer an age limit for regular IRA contributions.

A traditional IRA contribution is usually deductible, but deductions are sometimes limited if you have another retirement plan through your employer. Roth IRA contributions aren’t tax-deductible. With a Roth IRA, you still pay taxes on contributions, but then you can withdraw funds tax-free after retirement. Instead of getting a tax deduction on your contribution now, you can take out interest and growth without taxes after retirement.

There are additional contribution limits for Roth IRAs that depend on your modified adjusted gross income. The IRS generally counts self-employment and long-term disability as income. However, interest, dividends, alimony and child support aren’t factored into modified adjusted gross income.

IRA custodians are usually banks, credit unions, brokerage firms or trust companies. If you open an IRA account, keep in mind that the IRS requires that you make all contributions for the year by April 15.

Advantages and disadvantages of IRAs

The biggest benefits of an IRA are the tax advantages. While IRAs do have specific requirements when it comes to contributions and when you can take out money (e.g., having to pay penalties and taxes when withdrawing before age 59 ½ ), the straightforward nature of investing in an IRA is attractive to most novice investors.

We’ve broken down some of the main advantages and disadvantages of a traditional IRA below.

Pros

  • Tax-deductible contributions
  • Flexible investment options
  • Easy to open
  • Straightforward management
  • Tax-deferred growth

Cons

  • Taxable withdrawals
  • Penalties for early withdrawals
  • Forced withdrawals starting at 72
  • Low contribution limits

Frequently asked questions

What do you need to open a traditional or a Roth IRA?
In most states, anyone over the age of 18 can open a traditional or Roth IRA in minutes with only simple background information. You’ll need to choose where you want to open your IRA and what you want to invest in. Almost anyone can open up an IRA at most banks and financial institutions, regardless of whether or not they already have a 401(k) or another type of retirement savings plan.
How much money do you need to start an IRA?
It depends on your provider. Most IRAs don’t require a minimum amount of money in order to open, but some could.
Can you have traditional and Roth IRAs?
Yes, you can have both a Roth and a traditional IRA, as well as a 401(k), if you want. However, the contributions are still limited by the IRS. In recent years, the total you can contribute to any and all of your IRAs in a given year is $6,000 if you’re under 50.
How much will an IRA reduce my taxes?
It depends on the tax bracket you’re in and the type of account you open. You’ll be able to defer income taxes up to $6,000 for money deposited into an IRA. You’ll pay that income tax when you withdraw it from the account, though.
Can I take money out of my IRA?
Yes, but you’ll have to pay hefty fees if you’re under 59 ½. According to the IRS, this penalty is 10% plus the cost of gross income tax.
What is a rollover IRA?
A rollover IRA is a type of investment account that lets investors move their past employer-sponsored retirement plan investments, like 401(k), 403(b) or profit-sharing plan assets, into a traditional or Roth IRA. These plans let investors save the tax-deferred status of their assets without having to pay taxes or penalties.
Can you lose money in an IRA?
Yes. Because IRAs can be used to invest in various assets, there’s always the risk that an investment could lose value, depending on the market.

Bottom line: Is an IRA a good investment or a bad idea?

An IRA is a tax-advantaged investing tool with plenty of benefits, but every investment has some risk. There are many different types of IRAs; traditional IRAs have been around since the 1970s, but now Roth IRAs are becoming more and more popular. For those who want flexibility, a self-directed IRA might be the way to go.

For more options, read about how to find the best investment company, financial advisor or mutual fund company.

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Profile picture of Kathryn Parkman
by Kathryn Parkman ConsumerAffairs Research Team

As a member of the ConsumerAffairs Research Team, Kathryn Parkman believes everyone deserves easy access to accurate and comprehensive information on products and businesses before they make a purchase, which is why she spends hours researching companies and industries for ConsumerAffairs. She believes conscious consumption is everyone's responsibility and that all content deserves integrity.