Question: What is an IRA account and how does it work?
Answer: Let’s start with the easy part of this question: ”What is an IRA Account?”
The Employee Retirement Income Security Act of 1974 (ERISA) amended the US tax code to allow for the creation of an individual retirement arrangement (or IRA) account. IRA accounts were created as an incentive to increase personal savings.
Now, to the more complicated part: ”How does it work?”
Not all IRAs are the same, nor do they offer the same benefits. However, ultimately, they all have a single goal – to help you save and invest for your retirement years. All IRAs carry tax benefits for saving, but they also carry penalties for taking early withdrawals. In order to get the tax benefits available through IRA accounts, you must keep your money in the account until normal retirement age, which is usually 59 1/2. Otherwise, you could be subject to hefty penalties, fees and federal income taxes on withdrawals.
There are several types of IRAs. We’ll briefly cover the two that are most popular among savers – Traditional IRAs and Roth IRAs.
Traditional IRAs allow you to defer some of your current income – before it’s taxed – into an account. Within that account, you can usually make investments with your money. The money in your IRA account grows tax-deferred until you are ready to take a withdrawal. With a traditional IRA, you will only pay federal income taxes when you take money out of your account. Keep in mind though, as we mentioned above, that if you make a withdrawal before you attain age 59 1/2 you could face a penalty and income taxes on your withdrawal.
Roth IRAs, however, work in a slightly different way. You deposit money – after it’s been taxed – into a special IRA account. Just like the traditional IRA, you may choose to invest the funds in your Roth IRA. Your investment is allowed to grow tax-deferred and the income is tax-free; you never pay taxes on interest and earnings so long as you wait until age 59 1/2 before making withdrawals. If you take your money out too early, you may still face a penalty and income taxes on your withdrawal.