Individual Retirement Account (IRA): What Is It, Types, and How It Works

Ensuring financial security for your future retirement is something to start thinking about early in your career. While employer-sponsored savings plans provide a solid foundation, they may not be sufficient to build the retirement savings you need. Fortunately, contributing to an Individual Retirement Account (IRA) is an excellent way to supplement traditional retirement plans.

So, what is an IRA account, how does it work, and what are the different types of IRA accounts? By the end of the article, you’ll have all the answers—and much more. Read on to learn everything you need to know about the Individual Retirement Account.

What Is an IRA: Definition, Key Features, and Benefits

An Individual Retirement Account ​​is an investment account designed to help you save for retirement in a tax-efficient and profitable way. Depending on the type of IRA, you can reduce tax payments either when making contributions or during retirement withdrawals.

While IRAs are especially beneficial for self-employed individuals who do not have access to traditional workplace retirement plans, those with employer-sponsored accounts can also use IRAs to expand their retirement savings. This makes an Individual Retirement Account your flexible and powerful win-win option for gaining more control over your savings and accumulating even more money for anyone looking to take control of their financial future.

A fundamental benefit of an Individual Retirement Account is the increased freedom it provides in managing your investments for the future. Therefore, it offers exceptional features for those who want to save for retirement and feel that an employer-sponsored retirement plan doesn’t fully meet their retirement savings needs. The key benefits of an IRA are that this account provides access to expanded investment options and allows you to enjoy significant tax-free or tax-deferred money growth.

This account can be opened with banks, investment firms, credit unions, financial institution advisors, or brokers. While traditional IRAs are available to anyone with earned income, other IRA account types may have certain income limits, meaning these accounts may not be available to everyone. Regardless of the type you choose, IRAs will allow for faster accumulation of savings and greater control over your retirement strategy.

What Are the Types of IRAs?

Individual Retirement Accounts come in several types, and the division is based on the fundamental difference primarily in tax treatment and withdrawal rules—whether you pay taxes before depositing funds or after withdrawing funds, and when you need to withdraw your money.

Below is our complete overview of the main IRA types and differences.

Traditional IRA

A Traditional IRA is a tax-deductible retirement savings plan. So, for example, if you contribute $5,000 to your account, your taxable income for the year becomes smaller by exactly that amount. The tax rate for withdrawals in retirement is the same as your regular income tax rate.

If you want to withdraw money from your Traditional IRA without penalty, you must wait until you reach 59½. Keep in mind that if you want to take distributions from your retirement account earlier, the plan will charge you a 10% penalty. As for required minimum withdrawals, they apply once you reach a certain age based on your date of birth.

Roth IRA

In the case of a Roth IRA, the key point is that you are contributing to the account from funds on which you have already paid taxes. Unlike the previous type of retirement account, here, you can withdraw contributions without paying taxes and penalties at any time. Another important feature of this plan is that there are no taxes on investment income earned during retirement. The Roth Individual Retirement Account is an excellent option for taxpayers who are not planning to retire in the near future.

You can contribute to a Roth IRA as long as you earn income, regardless of your age. However, it comes with income limits, which means that the amount you contribute is reduced and may even be eliminated once you reach a certain income level. The Roth Account is excellent for diversifying your tax exposure and giving your money more time to grow and accumulate. No matter what tax bracket you’ll be in decades from now, a Roth IRA is a great way to build up some retirement savings that you can withdraw tax-free.

SEP IRA

The Simplified Employee Pension (SEP) IRA is a simplified retirement plan tailored for self-employed individuals, independent contractors, freelancers, or small business owners with no or a small team of employees.

Here, as with a Traditional IRA, contributions are tax-deductible—the employer puts funds into an IRA account that is opened for each employee. In general, a SEP one allows employees to save much more money than they can put into a traditional IRA. However, an important point is that employees cannot contribute money to their accounts themselves.

SIMPLE IRA

The SIMPLE IRA (Savings Incentive Match Plan for Employees) is a retirement savings plan tailored for employees of small businesses. Contributions to this plan are tax-deductible, providing both employers and employees with tax advantages.

So, how to use an IRA according to a SIMPLE plan? This type of Individual Retirement Account comes with the same withdrawal rules as a Traditional IRA. However, unlike a SEP IRA, it allows employees to contribute to their own accounts. Therefore, employers must make mandatory contributions, while employees have the flexibility to decide for themselves whether to allocate a portion of their paychecks to their retirement savings.

How Do IRA Accounts Work?

When you open an Individual Retirement Account, you are actually depositing funds that you control, deciding where to invest the money. However, it is important to note that IRAs are specifically intended for retirement. This means that according to the rules, early withdrawals from the account, in most cases, often incur a10% penalty and are subject to taxes. Therefore, to maximize the benefits of your IRA, the best time to withdraw money is before the age of 59½. In essence, the classic principle works here—the longer your funds remain in the account, the more they can grow due to the power of compound interest and investment returns.

How does an IRA work in terms of contribution limits? When discussing how an IRA operates, it is essential to highlight the annual contribution limits. As of 2024, these limits are set at $7,000 per year for individuals under 50, and $8,000 per single year for those aged 50 and older, which includes an additional catch-up contribution.

So, how to open an IRA? The first and most important thing is that you must have earned income from work. Opening an account is as easy as visiting a bank branch or filling out an online form. Remember that each provider offers different terms, so compare management fees, commissions, and account requirements among banks, credit unions, and investment firms to ensure you find the best option.

Final Thoughts

So, what is an IRA account? An Individual Retirement Account is a plan that you can contribute to throughout your career and withdraw money from in retirement. And while an employer-sponsored account may have limited investments, IRAs provide more opportunities for tax savings, increased investment options, and long-term growth.

To make your savings as profitable and effective as possible, you should take control of your investments and maximize contributions to grow your savings. Feel free to adjust your investment strategies as your goals and circumstances change.