What is an IRA? Basically, an IRA (Individual Retirement Account) is a savings account for retirement with big tax advantages. It is set up with a financial institution such as a brokerage firm, mutual fund company or bank.
A key thing to remember is that the term “IRA” just describes the account itself — i.e. the bucket of savings set aside for retirement. With the money in an IRA you can make investments in things like stocks, bonds and mutual funds.
Types of IRAs
There are many types of IRAs. Here are some of the most popular:
Traditional IRA – This is the most common type of IRA. It’s essentially a tax-deferred account, meaning that you usually only pay taxes when you withdraw the money in retirement. This allows investments to grow more quickly in your pre-retirement years. There are two types of traditional IRAs, “deductible” and “nondeductible”, which refers to whether you qualify for a tax deduction for your contributions.
Roth IRA – Roth IRAs are also hugely popular. One way to think about a Roth IRA is as a mirror image to a Traditional IRA. With a Traditional IRA you contribute pre-tax while working and are taxed in retirement. For a Roth IRA, you contribute money after you’ve already been taxed while working, but then pay no taxes when you withdraw funds in retirement.
There are also a few other differences between a Traditional IRA and a Roth IRA, and each has its own advantages and disadvantages. We suggest talking to a financial advisor to figure out if one or the other (or likely both) work for you. If you’re looking to do your own research, this tool from Fidelity could be a good starting point.
SEP IRA – This is basically a Traditional IRA for self-employed individuals and small businesses. Contributions are usually tax deductible for the business and there is flexibility on the frequency of funding. Only the business can make a contribution.
SIMPLE IRA – A SIMPLE IRA (Savings Incentive Match Plan for Employees) is another form of Traditional IRA for self-employed individuals and small businesses. Unlike a SEP, a SIMPLE mandates that the business match contributions up to a certain amount. Also unlike a SEP, a SIMPLE allows individuals to contribute to the account. In many ways, a SIMPLE is like a 401(k), but is simpler for businesses to set-up (get it?).
Self-Directed IRA – A self-directed IRA gives additional flexibility on the types of things you can invest your IRA money in. Usually self-directed IRAs are the domain of experienced (or risk loving) investors who well understand the pros and cons of various types of investments.
Rollover IRA — A Rollover IRA is a Traditional IRA intended for money “rolled over” from another retirement plan, usually from an employer-sponsored 401(k).
Photo by Philip Taylor PT via Flickr.