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What Is an IRA? You Might Be Surprised

By Selena Maranjian – Feb 7, 2014 at 7:00PM

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Some answers to the "What is an IRA?" question are unexpected.

What is an IRA? Most folks can tell you that it's a retirement savings account. And some folks could tell you that there are different kinds. But most of us are probably unfamiliar with many aspects of IRAs -- which is bad, as they can prove quite powerful in helping us fund a comfortable old age.

What is an IRA? A tax delayer or avoider
The best thing about IRAs is that they permit you to put off paying some taxes -- or bypass them entirely. With a traditional IRA, you contribute money to it each year on a pre-tax basis. So if you earn $40,000 and contribute $5,000, that $5,000 is subtracted from your taxable earnings, thereby decreasing your taxes in the current year. The money grows in that IRA until you withdraw it, at which time it's taxed at your income tax rate, which may be lower than your current rate.

The Roth IRA, meanwhile, accepts post-tax money, so it doesn't reduce your taxes up front. Instead, your money grows in the account, and when you withdraw it in retirement, it's not taxed at all! Even dividends collected in your Roth IRA are not taxed, meaning it can be a good place to park big income-generators, as well as stocks that you expect to grow briskly.

A patient money receptacle
Another good-to-know characteristic of IRAs is that you can contribute to them until tax day. So for the tax year 2013, which ended on Dec. 31, 2013, you can make an IRA contribution until April 15, 2014. (Be sure to specify which tax year your contribution is for, though, as it might otherwise be viewed as a 2014 contribution.)

A bigger container than you thought
If you haven't been keeping up with IRA annual contribution limits, they may be higher than you remembered. Back in 1998, the limit was $2,000. In 2002 it was $3,000, and in both 2013 and 2014, it's $5,500 -- plus an additional "catch-up" contribution of $1,000 for those 50 or older, for a total of $6,500.

You can see your IRA grow fatter faster by rolling over an old 401(k), 403(b), or 457 plan from a former job into an IRA (an existing one or a new one you set up). Many people just cash out these accounts, but that's generally a huge mistake, short-changing your future. (There are some situations where it's not the best move, but it often is.) This can give your IRA(s) a powerful boost, as 401(k)s might contain tens of thousands of dollars, or even hundreds of thousands, as their annual contribution limits are higher, and many companies even match a portion of contributions.

A versatile container
While a typical 401(k) plan might permit you to invest in a limited assortment of investments -- perhaps about a dozen, including mutual funds, guaranteed investment contracts, stable value funds, company stock, and variable annuities -- IRAs are often maintained at brokerages, where you have access to hundreds or thousands of mutual funds and thousands of stocks, bonds, ETFs, and more. IRAs can also hold much more than that. A "self-directed" IRA will let you invest in gold and silver bullion coins, a franchise business, real estate, and more -- even racehorses! It's not for everyone, though, and simple stocks, bonds, ETFs, and mutual funds can serve most investors just fine.

A home-purchase funding source
There's a first-home exemption rule that permits an individual to withdraw up to $10,000 from an IRA for a first-time home purchase. This can be done before age 59 and a half without triggering the 10% early-withdrawal penalty. Married couples can generate $20,000 toward a down payment this way. If this is of interest, read up on the rules.

A shape-shifter
The traditional and the Roth IRA are the main kinds of IRAs, but there are many others. The SEP IRA, for example, is great for self-employed folks and also permits employers to contribute to employee IRA accounts. A Simple IRA is another option for small businesses and the self-employed. There's even a Spousal IRA for spouses without the earned income that's typically necessary for funding an IRA.

An estate-planning tool
A Roth IRA can even serve as a handy estate-planning tool, permitting you to pass accumulated wealth on to your descendants without penalty.

Clearly, IRAs have a lot to offer those who know how to make the most of them. If you don't already have one or more, look into whether you should.

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