What Is an IRA?

Elizabeth MacBride

Traditional IRAs are a great way to save for retirement. We cover the details here.

Quick Summary:

  • IRAs are special savings accounts that help you save for retirement by offering a way to save on your taxes. With a Traditional IRA, you don't pay taxes on your contributions and gains until you withdraw the money in retirement.
  • IRAs can be opened by anyone who works or has a working spouse. There are two kinds of IRAs: a Traditional IRA and a Roth IRA.
  • Traditional IRAs allow you to save up to $5,500 per year ($6,500 if you are 50 and older) and deduct eligible contributions from your income tax.
  • You can invest in many different kinds of stocks, bonds, mutual funds and other investments within an IRA. You typically open an IRA at a brokerage or a bank.

What Is A Traditional IRA?

A Traditional IRAs can be a great way to help you meet your retirement goals. They are savings accounts that let you put aside money for retirement, while you deduct the amount you contribute from your income tax. We’ll discuss some of the key elements here:

  1. How does a Traditional IRA work?
  2. What are the tax advantages?
  3. What are the rules?
  4. How do I invest in my Traditional IRA?
  5. Other Important Considerations

How Does a Traditional IRA Work?

A Traditional IRA works to help people save for retirement because of its tax advantages.

You can deduct the contributions you make to a Traditional IRA. The returns you earn on your investments in your Traditional IRA aren't taxed either. Most people benefit most when they start and fund a Traditional IRA when they are young. Over time, the tax savings and the returns on your investments add up.

In 2015, you are allowed to sock away up to $5,500 per year ($6,500 if you are 50 and older) and invest it. You pay taxes later, when you withdraw the money after you retire.

With a Roth IRA, you don't get a deduction when you save the money. Instead, you can withdraw money tax-free after you are retired. Whether a Traditional IRA or a Roth IRA is best depends on your own personal situation.

What Are The Tax Advantages of a Traditional IRA?

The tax advantages on a Traditional IRA mean you earn more from your money than you would from money in a savings account. Traditional IRAs are particularly useful for people who don't have retirement plans at work (although may people have both a  401k and an IRA. They open IRAs after they have put enough money into their 401ks to get their employer match.)

Here’s an example of how the tax savings on a Traditional IRA can help.

If you save $100 a month for 30 years, assuming you earn a 6% return, you'll have about $101,000 a the end in an IRA. In a regular savings account, after you pay taxes at a 25% rate, your end total over the same 30 years will be $76,000. Even considering the taxes you'll pay as you gradually withdraw the $101,000, you will come out ahead by saving with the tax advantages of an IRA. That's because there are no taxes to reduce your gains over the years.

Most Americans can defer taxes on their contributions, with one exception. If you or your spouse is covered by a retirement plan at work (like a 401k or 403b), and you make a significant amount of money, you may not be able to deduct your traditional IRA contributions from your current year’s taxes. If you make more than $61,000 a year for 2015 ($98,000 for married couples filing jointly), your deduction is reduced. If you make more than $71,000 ($118,000 for married couples, you get no deducation at all -- if you are covered by a workplace plan.

How Do I Invest My Traditional IRA?

Money invested in your IRA can be invested virtually any way you like. Normally, you open an IRA account with a bank or brokerage company. You can expect a brokerage to have a customer service department that will help guide you through opening an account and putting money in it.

Your investment options will generally include cash, CDs, stocks, bonds, mutual funds, exchange traded funds (ETFs) and may include others, too. When you pick your investments, look for low fees and investments you can understand. You can also talk to a financial advisor who can help you pick the investments for your retirement portfolio.

Often, you can open an IRA at a large brokerage like E*Trade for free and with no annual fee, but you must pay a fee for each trade. Some brokerages that charge an annual fee will waive it if you set up automated deposits from your bank account. Many brokerages have a minimum deposit, such as $500 or $1,000, to open an IRA, but a few have no minimum.

What Are The Rules For IRA Contributions?

You can open an IRA, as long as you will be younger than 70 1/2 at the year’s end, if you are working or receive long-term disability benefits. If you do not have a paying job, but your spouse has taxable compensation, you can still open an IRA. Once you reach 70 ½, you’re no longer eligible for a traditional IRA, whether you work or not.

Excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA. The tax can’t be more than 6% of the combined value of all your IRAs as of the end of the tax year.

If you roll over money from other retirement accounts, such as a 401(k) from a previous job, that amount does not count toward your contribution limit.

Some other kinds of IRAs, including Simple IRAs and SEP-IRAs, allow people to contribute more. But they are available generally only to small business owners.

Watch Out For Fees

When you shop for a brokerage to open your IRA, look for a no-fee IRA. A free or no-free IRA means that the brokerage isn't charging you to hold or manage the account. But there are still still fees on the underlying investments. Online brokers like Fidelity, E*TRADE, Merrill Lynch and Schwab offer thousands of mutual funds, stocks, bonds, ETFs and other options. Look at the expense ratios of the funds you buy. Consider the commission you pay on each trade as you buy and sell investments within your IRA.

Many brokerages offer funds, often called "lifecycle funds" or "target date funds" designed to help you meet a specific goal, such as retirement, by a certain date. For example, Fidelity's Freedom Funds and Vanguard's Target Date Funds automatically adjust their investments to reduce the risk at you will lose money as you approach your retirement date.

Minimum Distributions Are Required

Once you turn 70 ½, you also must take what the government calls “required minimum distributions” from your Traditional IRA. Simply put, you need to start withdrawing a percentage of your savings every year. The calculation can be confusing, so many people consult a tax advisor or financial advisor. You can find help from the IRS calculating the required minimum distribution here.

The Bottom Line

 An IRA can help you meet your retirement goals. If you save $5,500 annually for the next 30 years, you will end up with more than $430,000, assuming a fairly conservative rate of return of 6%. But don't wait: time and tax savings are your best allies.

 

Compare Popular IRA Providers

FIDELITY INVESTMENTS

MERRILL LYNCH

E*TRADE

Fidelity IRA Merrill Edge IRA E*Trade IRA

Get a range of investment choices, tax advantages and 1:1 help with a Fidelity IRA

Get up to $600 when you invest in a new Merrill Edge IRA. Plus one-on-one guidance, actionable insights and easy-to-use tools.

Open an E*TRADE IRA. No Fees. No minimums.

Learn More» Learn More» Learn More»
Important IRA Information

Each year, the IRS updates the rules for Traditional IRAs. Here are all the details for 2015: