What Is an IRA?

If you're planning for your retirement, some of the best questions you can ask are: "What is an IRA?" and "Is it right for me?"

Aug 31, 2014 at 2:15PM

If you're thinking about your retirement, you may have heard that an IRA can be an important part of your plan. But if you're just getting started, you may still be wondering: What is an IRA? IRA stands for "Individual Retirement Arrangement," and it's a tax-advantaged way for you to invest for your retirement.

There are four basic types of IRAs, and each has different rules. All IRAs offer tax-deferred compounding once your money is invested in the arrangement, but beyond that, they differ in terms of how they work and how much funding you can put into them.

Is an IRA that complicated?

On the surface, it may seem there are a lot of moving parts involved in figuring out how to use an IRA to invest for your retirement. The key features of the different types of IRAs are outlined below.

Traditional IRAs
You can contribute up to $5,500 ($6,500 if you're age 50 or older) so long as you and/or your spouse (if filing jointly) have sufficient taxable compensation. You may get a tax deduction when you contribute, but your gains are eventually taxed as ordinary income when you take the money out. You can't contribute past age 70-1/2, and indeed, once you reach that age, you have to start taking "required minimum distributions."

Roth IRAs
You can contribute up to $5,500 ($6,500 if you're age 50 or older) so long as you and/or your spouse have sufficient taxable compensation, but there are income limits above which you can't contribute. You do not get a tax deduction when you contribute, but qualifying withdrawals can be taken out completely free from income taxes. You can contribute at any age, and you are never required to take a minimum distribution from your own Roth IRA (though you might be required to if you inherit an IRA).

SEP IRAs
This type of IRA is funded by your employer on your behalf. Your employer can invest up to 25% of your compensation, up to a limit of $52,000. You're immediately vested in the money your employer contributes, and the company must contribute equitably for all eligible employees. When it comes to withdrawals, the SEP IRA is generally treated like a traditional IRA.

SIMPLE IRAs
The SIMPLE IRA is funded by both you and your employer, but it is only available to smaller companies. You can contribute up to $12,000 into your SIMPLE IRA ($14,500 if you're age 50 or older). Your boss can either choose to match your contribution dollar for dollar up to 3% of your compensation (with no dollar limit) or provide a nonelective contribution of 2% on up to $260,000 of your compensation. From a withdrawal perspective, a SIMPLE IRA is generally treated like a Traditional IRA.

Which type of IRA is best?

Unless your employer offers a SIMPLE IRA or a SEP IRA, most people choose between the traditional IRA and the Roth IRA. Your choice will depend on your individual circumstances, but here are some general guidelines.

If you're eligible to contribute to either a traditional IRA or a Roth IRA:

  • If you are not able to deduct a traditional IRA contribution, the Roth IRA is worth more to you than the same contribution to a traditional IRA because of the potential for tax-free withdrawals.
  • If you are able to deduct a traditional IRA contribution but cannot reach the maximum contribution level, it's more or less a wash. The tax break now from a deductible IRA can help you get closer to filling the account and thus let more of your money compound for you tax-deferred. On the flip side, in retirement, the Roth IRA money could come out completely tax-free, helping make up for the lower base.
  • If you are able to contribute the full $5,500 (or $6,500 if age 50 or older), the Roth IRA will probably be more useful in retirement than a traditional IRA because of the possibility of tax-free withdrawals. Think of it this way: When it is time to retire, you'll likely be pulling money from your IRA to cover your costs. If you need to withdraw $15,000 to live and are in the 10% tax bracket, you'd actually need to pull $16,666.67 from your traditional IRA to cover those costs plus taxes. With a qualified tax-free withdrawal from the Roth IRA, however, you could withdraw just the $15,000 you need. That leaves more in the plan from the same initial investment (though that investment will cost you more up front).
  • If you're only eligible to contribute to a traditional IRA (typically due to income) but want a Roth IRA instead, you may want to check into something known as a "backdoor Roth IRA." This strategy involves contributing money to a traditional IRA and then converting that Traditional IRA to a Roth IRA, paying taxes on any amount converted above your non-deductible basis. This may be an attractive option, but be mindful of the record-keeping it creates.
  • If you're only eligible to contribute to a Roth IRA (typically due to age), remember that the Roth IRA has great estate-planning benefits in addition to being a powerful retirement-planning tool.

All told, an IRA can be a great vehicle to help you fund your retirement. The tax-deferred compounding these arrangements offer can help you build your nest egg more efficiently. And the more efficiently you can build your nest egg, the easier it will be to assure your golden years are truly golden.

How to get even more income during retirement
Your IRA and Social Security can work together to play key roles in your financial security, but they're not the only way to boost your retirement income. In our brand-new free report, our retirement experts give their insight on a simple strategy to take advantage of a little-known IRS rule that can help ensure a more comfortable retirement for you and your family. Click here to get your copy today.

Chuck Saletta is a Motley Fool contributor. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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