IRA 101: The Beginner's Guide to IRAs

IRA 101: The Beginner's Guide to IRAs

IRAs are a powerful tool that can help you secure your financial future. Despite how important an IRA can be for your retirement planning, many investors are unsure about the fundamentals of IRAs and how they can impact their future.

In this IRA 101 guide, we discuss the basics of IRAs to help you decide if they are the right fit for your financial future.

What Is an IRA?

An IRA (or Individual Retirement Account) is a type of savings account that’s designed to help you save for retirement. One advantage of an IRA is that it can grow your money in a tax-sheltered account.

This benefit means your money can grow much faster than in a regular savings account where you would pay taxes on interest as you earn it. While the funds grow “tax-free,” this doesn’t mean that you won’t pay any taxes, but rather that, depending on the type of IRA you select, you may be able to structure your taxes in a way that’s beneficial for your lifestyle.

Investors can use an IRA to invest in stocks, bonds, mutual funds, cryptocurrencies, precious metals and other types of investments that typically offer higher interest rates than a standard savings account.

Different types of IRAs have different tax benefits, but no matter which type is right for you, IRAs are one option to consider for retirement if you are hoping to see more growth during the initial investment.

Different Types of IRAs

While the general structure of an IRA stays the same, there are different approaches to IRAs that may benefit you depending on your lifestyle. This IRA 101 guide will cover traditional and Roth IRAs, the two popular types of IRAs, as well as SEP IRAs -- a special type of IRA for business owners and self-employed individuals.

Traditional

A traditional IRA allows individuals to save for retirement on a tax-deferred basis. That means that any contributions you make to a traditional IRA come from your pre-tax income, which can help reduce your overall tax liability for the year when you file your taxes.

Once you’ve contributed money to a traditional IRA, it compounds tax-free until you withdraw at retirement. Waiting until retirement to withdraw could mean you are in a lower tax bracket, which means your total tax liability would be, in theory, lower as well. 

Another advantage of a traditional IRA is that since investors make contributions with their pre-tax earnings, it reduces their taxable income for the year in which they made the contribution. This doesn’t mean investors don’t pay taxes—rather, that they defer their tax liability until they withdraw funds in retirement, so reducing their taxable income in the short-term to pay taxes in a lower tax bracket later in life could be advantageous for some investors.

Roth IRA

Similarly, Roth IRAs allow investors to invest their money in a tax-deferred way, but with a unique twist: while a traditional IRA uses pre-tax dollars, Roth IRAs use after-tax dollars. Why is this advantageous?

With a traditional IRA, investors pay taxes when they withdraw money at retirement. They didn’t have to pay taxes as their investments compounded, but the side-effect is that since their investments generally grow over time, investors end up paying taxes on a higher amount than their initial contribution.

While a Roth IRA doesn’t have the immediate tax benefit of reducing the investor’s taxable income for the year in which a contribution was made, the main benefit is that since the investor has already paid the taxes on that money, they don’t have to pay additional taxes when they withdraw it at retirement.

Another difference between traditional and Roth IRAs is that traditional IRAs come with timing requirements: investors can’t generally make withdrawals before the age of 59 ½ and are required to start taking withdrawals by the age of 72. Roth IRAs still have the same minimum age to make withdrawals, but they don’t include a maximum age to start taking withdrawals, meaning investors can leave their funds in a Roth IRA for longer, giving their investment more time to compound.

These differences in Roth IRAs make them suitable for individuals who expect to be in a higher tax bracket during retirement, only because there are no taxes at the time of withdrawal. 

SEP IRAs

While less common than traditional or Roth IRAs, a SEP (Simplified Employee Pension) IRA specifically caters to self-employed workers and small business owners. A SEP IRA allows business owners to make contributions to their own retirement accounts and the accounts of their employees, if they have any.

Both traditional and Roth IRAs have maximum contribution amounts which change yearly. SEP IRAs have higher maximum contribution amounts, so they’re ideal for business owners who have strong retirement savings goals.

SEP IRAs function similarly to traditional IRAs—businesses contribute funds with pre-tax dollars, which they pay taxes on when they withdraw the funds at retirement. One major distinction between a SEP IRA and a traditional IRA is that in the same way traditional IRAs reduce the taxable income of the individual, SEP IRAs reduce the taxable income of the business entity because contributions to a SEP IRA are tax-deductible.

Why Do People Use IRAs?

IRAs have the potential to create higher average rates of return than traditional savings accounts. This is in part because they allow individuals to invest in stocks, mutual funds, and other non-cash assets like precious metals or cryptocurrency (in the case of a self-directed IRA), but also because funds in IRAs are tax deferred. That means the investor pays taxes when they invest or withdraw money (depending on the type of IRA), but not when their money accumulates interest, greatly increasing their rate of return over time.

IRAs are well suited for retirement savings because of their flexibility and tax benefits, but many investors still find themselves unsure about how to get started. iTrustCapital offers all three types of these IRAs for clients planning for their financial future.

To learn more about creating an IRA that suits your lifestyle needs or retirement goals, open an account today!