An Individual Retirement Account (IRA) serves as a tax-advantaged investment tool for retirement savings. While technically standing for Individual Retirement Arrangement, colloquially, the 'A' in IRA refers to an account.
For the 33 percent of private industry workers in the U.S. lacking access to a workplace-based retirement plan, IRAs offer a valuable solution. Often, the absence of a 401(k) leads to inadequate retirement savings. IRAs, however, provide all workers, even those with access to a workplace plan, a convenient means to prepare for retirement.
It's crucial to recognize that IRAs aren't just for those without a workplace plan; they can be ideal for the 67 percent who do. Whether maxing out contributions or seeking more control over investments, an IRA offers an additional avenue for saving towards retirement.
How does an IRA work?
Comparing an IRA to a regular taxable brokerage account for retirement is akin to choosing between the E-Z Pass lane and stopping at toll booths every 20 miles. Opening an IRA involves contributing funds that can be invested in various assets like CDs, stocks, bonds, and more, providing greater control than a 401(k). Investors can tailor their investment strategy, seeking assistance from robo-advisors or opting for target-date retirement funds if needed.
Asset allocation, determining how funds are distributed among stocks, bonds, and other investments, is crucial for future earnings. IRAs allow flexibility in adjusting these investments without incurring capital gains taxes, enhancing adaptability to changing market conditions.
While flexibility exists in moving funds, early withdrawals before the age of 59 1/2 incur both taxes and a 10 percent penalty, unless used for special exceptions like buying a first home or higher education.
Types of IRAs
IRAs come in two types: traditional and Roth, differing in tax implications and withdrawal requirements.
Traditional IRA: Offers a tax deduction for contributions (up to a capped amount) but taxes are levied on withdrawals. Mandatory withdrawals begin at age 73.
Roth IRA: No immediate tax break; taxes are paid on income upfront, but withdrawals in retirement are tax-free. No mandatory withdrawals.
How to open an IRA
Opening an IRA requires earned income from working, and it can be done at various institutions, including brokerage firms, mutual fund companies, banks, and credit unions. Attention to fees, commissions, and minimum opening requirements is crucial, and assessing available educational resources for self-directed investing is advisable.
401(k) vs. IRA
Both 401(k) and IRA offer advantages, but a 401(k) often holds the edge due to higher contribution limits and potential company matching. A 401(k) allows contributions up to $23,000 (for 2024), compared to $7,000 in an IRA, with more substantial catch-up contribution limits for those 50 and older. Additionally, a 401(k) may come with a company match, providing an immediate return on investment, making it a preferred choice for many.