Individual retirement accounts (IRAs) - How they work

An IRA is a tax-advantaged savings account for individual taxpayers to earmark their retirement savings. IRAs were established in 1975 by the Internal Revenue Service (IRS) as a vehicle for investors to prepare for retirement.

Your IRA is a holding account in which you maintain positions in stocks, mutual funds, bonds, and private investments. IRAs act as tax-deferred or tax-free investment forms that are available at many financial institutions. 

The key difference between an IRA and a 401(k) retirement plan is that the latter is offered by employers, while IRA accounts are opened by individuals. The good news is, you can contribute to both an IRA and a 401(k) simultaneously, letting you invest in different categories and take advantage of excellent tax benefits.

To be eligible for an IRA, you must meet a number of requirements, of which the most important is that you have to have earned income as determined by the IRS. You cannot contribute income from investments, inheritance, Social Security benefits, or child support to an IRA account. 

The IRS limits the amount of funds individuals can pay into an IRA account. In 2021, the total contribution to traditional and Roth IRAs cannot exceed:

• $6,000 ($7,000 if you're 50 or older), or

• your taxable compensation for the year, if your compensation is less than the above dollar limit.

As soon as you turn  59½, you can start to withdraw money from your IRA account in the form of qualified distributions, provided you meet the criteria for qualified distributions set by the IRS. Taking out your savings before that age may qualify as early withdrawal and could cost you a penalty of 10%. You will have to pay income tax on the qualified distributions if you have an IRA account that allows for tax deferral. The rules governing maximum contributions and income limits for IRAs change each year.

Starting at age 72, holders of IRA accounts (except Roth IRAs) must begin taking required minimum distributions (RMDs) based on the size of their account and life expectancy. To calculate the amount of your RMD, take your account balance as of Dec. 31 of the previous year and divide it by the distribution factor that you can find in the calculation worksheets on the IRS website. For most people, the factor number ranges from 27.4 to 1.9. As a person gets older, the factor number goes down.

Here's an example.

Cathy is 74 years old and has a total of $375,000 in her IRA account. She had a balance of $355,000 on Dec. 31. The formula to calculate the required minimum distribution is: 

RMD = $355,000 ÷ 22.9 = $15,502.18

So Cathy has to withdraw at least $15,502.18 from her IRA account.

Failure to take RMDs may result in a tax penalty equal to 50% of the amount of the required distribution.

As you may have guessed by now, IRAs come in many shapes and sizes to fit the retirement needs of different people. Each type varies in terms of how contributions and withdrawals are made.

There are four main types of IRAs: 

• Traditional IRA 

• Roth IRA

• SEP ( Simplified Employee Pension) IRA 

• SIMPLE (Savings Incentive Match Plan for Employees) IRA

Some lesser known IRA types include backdoor Roth, spousal, inherited and rollover. They all have different advantages and limitations. Traditional or Roth IRAs are designed for individual taxpayers, while SEP and SIMPLE IRAs are available to small-business owners and self-employed individuals.

Selecting the right type of IRA depends primarily on your employment status and the size of your paycheck. Consult a professional before making a final decision. 

Opening an IRA account will likely save you many financial headaches once you retire. One of the biggest benefits of an IRA is that, unlike a 401(k), it isn’t tied to your employer and offers way more flexibility in how you invest your money. Here are the key reasons why setting up an IRA account is the responsible and financially rational thing to do: 

• Tax deductions or deferred taxes can translate into higher returns

• Compounded returns

• Access to Saver’s Credit

• Regular contributions ensure you don’t invest heavily at a market high

You can open an IRA account at a bank, brokerage firm, mutual fund company, insurance company, or at various other types of financial institutions. If you set up a self-directed IRA, you will be allowed to manage your investments, otherwise the service provider will do it for you. Funds held in an IRA account can be invested in a wide array of assets, including CDs, government bonds, mutual funds, and stocks.