What is an IRA?

ira painted egg

To retire comfortably, you may need to save up to 85 percent of your pre-retirement income. Just a 401(k) may not help you accumulate significant savings and when you account for inflation, your purchasing power may drop as you settle into retirement. That’s why so many Americans are IRA account holders. If you want to know what is an IRA, read on.

An individual retirement plan

As its name implies an Individual Retirement Account is an account that you open on your own as a retirement planning solution. It is different from a 401(k) provided by your employer, where they can contribute or match your contributions. You can open an IRA at a bank, brokerage firm, mutual fund company or automated investment service. IRA providers are licensed custodians of your money, offering you a variety of investment options and imposing tax penalties on early withdrawal of retirement funds for non-allowable purposes.

How much you can contribute towards each plan also differs. For instance, the basic contribution limit for a traditional IRA is $5,500, which increases to $17,500 for a 401(k). If you’re aged 50 years or above, you’re entitled to an extra catch-up contribution of $1,000 in your IRA and a corresponding $5,500 for your 401(k).

Why open an IRA?

Now that you have an idea about what is an IRA, let’s look at why you should consider opening one.

To accumulate a significant retirement income. Funding commitments and priorities at different stages of your life – from getting married and buying a home to child birth, vacations and college expenses – will inevitably cost a small fortune. If you contribute $5,500 a year in your IRA for 30 years at a return of 5%, you would have approximately $385,000 in retirement income.

To save taxes. You can deduct your IRA contributions from your taxable earnings. Note : You are entitled to a full, partial or no deduction if you also have an employer-sponsored retirement plan.

Types of IRAs

There are a total of 11 types of IRAs, but the four popular ones are:

Traditional IRA: A regular set-up where you make contributions for tax-deferred growth and deductions on income tax returns. Tax deferrals help retirees – whose tax bracket is lower than when they were in their jobs – by taxing their money at a lower rate. It is available to anyone under the age of 70 ½ years drawing an income from a job. Withdrawals begin and are taxed when the account holder turns 70 ½ years of age.

Roth IRA: Here, you make contributions from your after-tax income for tax-free growth and tax-free withdrawals post retirement. Withdrawals are allowed only after you turn 59 ½ years of age or a penalty must be paid.

Rollover IRA: Here, you transfer funds from a retirement account from a qualified retirement plan such as a 401(k). If you have changed jobs or retired and have assets in your employer-sponsored retirement plan, you can roll over to a traditional or Roth IRA via a direct transfer or a check.

SEP-IRA: This is a traditional IRA that an employer sets up for employees. Contributions made by the employee cannot exceed the lesser of :

25 percent of employee compensation OR

$53,000 (2015 figure)

A thorough understanding of what is an IRA and the different types of IRAs can help you choose one that saves you more tax and increases your retirement savings.

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