What is an individual retirement account (IRA)?

While saving for retirement can feel overwhelming, using an individual retirement account, or IRA, is a popular way of making the process easier — and more effective.

IRAs are flexible, tax-advantaged investment accounts that encourage you to invest more of your money for the future. Whether you’re just starting your career or have had an employer-sponsored retirement plan in place for a while, an IRA can be a great tool to achieve financial security and reach your retirement goals.

What is an IRA?

An IRA is a type of long-term investment account that allows you to put money toward your retirement while taking advantage of tax benefits. You have a number of options for investing your IRA funds, including stocks, bonds, and mutual funds. IRAs are relatively easy to open and typically allow your money to grow faster than it would in a taxable account.

What are the different types of IRAs?

There are two main types of IRAs: traditional and Roth. The primary difference between a traditional IRA and a Roth IRA is when you get to take advantage of the account’s tax benefits.

Contributions to a traditional IRA are usually tax-deductible, meaning you deduct the amount you contribute from your taxable income for the year. The investment growth within the account is tax-deferred — in other words, you don’t pay taxes on the earnings until you withdraw the money after retiring. These withdrawals are generally taxed as ordinary income.

For many older adults, this is beneficial because they’re likely to be earning significantly less money in retirement than in their working years. As a result, they may pay lower tax rates on their retirement funds upon withdrawal than if they’d paid taxes on them earlier on.

Contributions to a Roth IRA are made with after-tax dollars, meaning you don’t get an up-front tax deduction. Instead, the investment gains you accumulate within the account are tax-free, as are qualified withdrawals. Unlike a traditional IRA, there are income limits for contributing to a Roth IRA. Roth IRAs are often beneficial for younger individuals who are likely to be paying higher tax rates in the future.

Both types of IRAs have contribution limits set by the Internal Revenue Service (IRS), which may change over time. In 2023, the combined annual contribution limit for both traditional and Roth IRAs is $6,500, with an additional $1,000 “catch-up” contribution allowed for individuals who are 50 or older. This means that once you reach age 50, you can start contributing $7,500 annually to your account.

One other thing to note: There is something called a SEP-IRA, or Simplified Employee Pension Investment Retirement Account. It’s generally built for self-employed people, including business owners, to offset the lack of traditional 401(k) options for retirement savings. You can learn more about SEP-IRAs here.

How to set up an IRA

Here’s how to get started:

Determine the type of IRA account you want to open: Decide whether you want to open a traditional IRA or a Roth IRA. Consider factors like your income, tax situation, and long-term financial goals. This decision will determine the tax treatment of your contributions and withdrawals, so don’t choose without carefully thinking it through.Choose a financial institution: Research and select a reputable financial institution that offers IRAs. This can be a bank, credit union, brokerage firm, or online investment platform. Consider factors such as fees, investment options, customer service, and convenience, as well as the types of assets you can transfer into the account if you already have a taxable brokerage account you’re looking to consolidate.Gather the required information: Once you’ve chosen a financial institution, gather the necessary information and documents. These typically include your Social Security number, contact information, employment details, and a valid form of state-issued photo identification. Passports, driver’s licenses, and military IDs are usually acceptable options when you’re opening an account.Complete the application: Fill out the application provided by the financial institution. You can often do this online or by visiting your IRA provider’s local branch. Provide accurate information and carefully read the terms and conditions.Fund your IRA: After your application is approved, your IRA provider will open up your account and assist you in funding it. Decide how much money you want to contribute to your IRA. Ensure that your contribution falls within the annual limits set by the IRS, but also make sure it works with your personal budget. You may make a one-time lump-sum contribution or set up automatic recurring contributions from your bank account.If you have a self-directed an IRA in a brokerage account, determine how you want to invest the funds within your IRA. Your account will likely offer various investment options, such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Consider your risk tolerance, time horizon, and investment objectives when making your selections.Monitor and manage your IRA: Regularly review your IRA’s performance, adjust your investments as needed, and track your contributions. You can check on your investments’ price changes to see how they are increasing or decreasing in value over time — usually, you can view this in your account statements or on your account’s online dashboard. Consider consulting with a financial advisor to manage your retirement savings effectively.

The specific process that you’ll follow to open your account might vary depending on your provider.

The pros and cons of IRAs

IRAs offer both pros and cons that you’ll need to consider before choosing where to invest your funds. Some of the benefits include:

Tax advantages: One of the primary benefits of an IRA is the potential tax advantages. With a traditional IRA, your contributions may be tax-deductible, reducing your taxable income for the year. In a Roth IRA, although contributions are made with after-tax dollars, qualified withdrawals in retirement are tax-free. These tax benefits can help you save money and potentially grow your retirement funds faster than in taxable accounts.Retirement savings growth: When you invest your contributions in financial instruments such as stocks, bonds, mutual funds, or ETFs, your IRA has the potential to appreciate in value and/or earn interest. What’s more, you may see a compounding effect of these gains over time.Additional retirement savings: IRAs provide an opportunity to save additional money specifically for retirement beyond what you may already contribute to an employer-sponsored 401(k) plan. This can be especially beneficial if your employer’s plan has limited investment options.

However, there are a few IRA drawbacks to be aware of:

Contribution limits: IRAs have annual contribution limits set by the IRS. As of 2023, the limit is $6,500 per year. (Those over 50 can contribute $7,500 per year.)Early-withdrawal penalties: IRAs are designed for long-term retirement savings, and there may be penalties for withdrawing funds before reaching age 59 1/2. Early withdrawals from a traditional IRA are generally subject to income tax and a 10% penalty. You can withdraw Roth IRA contributions penalty-free, but earnings may be subject to the 10% penalty and taxes.Required minimum distributions: Traditional IRAs require you to start taking a certain amount out of your account, known as required minimum distributions, after reaching age 73. These distributions are subject to income tax. RMDs can reduce the tax advantages of traditional IRAs and may force you to withdraw more than you need, potentially impacting your overall financial plan.

How is an IRA different from a 401(k)?

An IRA differs from a 401(k) in a few ways.

An IRA is a personal retirement savings account that you can open independently. Like a 401(k) plan, it offers certain tax advantages and allows you to choose from a wide range of investment options.

On the other hand, a 401(k) is an employer-sponsored retirement plan offered by companies to their employees. It allows employees to contribute a portion of their salary toward retirement, usually on a pre-tax basis and often with employer-matching contributions. In general, 401(k) plans have higher contribution limits than IRAs, and they may offer additional features like loan provisions.

A 401(k) uses before-tax income, thereby lowering your taxable income (and your income tax bill). Your 401(k) also grows tax free. As with a traditional IRA, your qualified withdrawals will be taxed, but possibly at  a lower rate because, in retirement, you may earn a lower income.

How Haven Life can help you prepare for the future

Opening an IRA is just one of the many ways that you can plan for and invest in your future. Another way you can protect yourself is by purchasing a life insurance policy.

Term life insurance from Haven Life can give you and your family peace of mind when it comes to financial security should something happen to you. Start with a free online quote today, and learn how term life insurance coverage can also work to keep you on track toward a bright financial future.