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How does an IRA Work? Understanding the Basics

Sandy Guidicianne, Director, First Republic Bank
November 10, 2021

Having a solid financial plan for retirement is the surest path to living comfortably without financial worry or burdens during your retirement years. One of the top solutions to building a strong retirement fund is opening an individual retirement account, more commonly known as an IRA.

So what is an IRA account, and is it right for you? Read more about why IRAs are a powerful, proactive tool for your retirement savings. Your future self will thank you.

What’s an individual retirement account (IRA)?

An IRA is an investment account designed to provide you with financial security in your retirement years. So how does an IRA work? 

Like with other retirement accounts, the funds you deposit into an IRA are meant to stay and grow there at least until you turn 59.5 years old. Early withdrawals may be subject to taxes and a 10% early withdrawal penalty.

The Internal Revenue Service (IRS) also has established IRA contribution limits. For example, in 2021, the total annual contribution you can make to all of your IRAs is $6,000, or $7,000 for those who are 50 or older.

Understanding the basics of how an IRA account works will prepare you to choose which type is right for you. Although several different types of IRAs are out there, two main types of IRAs are most popular.

Types of IRAs

The two primary types of IRAs that individuals open themselves are traditional IRAs and Roth IRAs.

Other types of IRAs for various situations (more on that below) are also available for those in need of a more unique retirement investment option.

But first, let's compare the two main types.

Traditional IRA

With a traditional IRA, you enjoy tax benefits now but have to pay taxes later on. In other words, contributions are made with pre-tax dollars and are tax-deferred. Contributions to a traditional IRA are tax-deductible (though that benefit may diminish at higher income levels and access to employer-sponsored plans such as a 401(k)). When you finally do withdraw contributions during retirement, the amount of taxes you pay will be based on your tax bracket at the time of the IRA withdrawal. 

Benefits

Drawbacks

  • Open to anyone who earns taxable income can contribute to a traditional IRA
  • Offers tax-deferred growth on your funds
  • Best for those who expect to have a lower tax bill in retirement

 

 

 

  • Subject to a 10% early withdrawal penalty, plus you’ll owe income tax on pre-tax contributions and gains if you withdraw money before age 59.5 (unless you qualify for an exemption)
  • No tax deduction on contributions for high earners who have access to an employer sponsored plan
  • By age 72, you must begin taking required minimum distributions (RMDs) from your IRA or you will be penalized

Roth IRA

Roth IRA works differently from a traditional IRA. You fund a Roth IRA with after-tax dollars, and there is no tax deduction when you contribute. But when you make withdrawals, there are no taxes to pay. The money you put into a Roth IRA — and everything it earns — is yours, free and clear.

The other big difference is that contributions to your Roth IRA can be withdrawn at any time. Once the account is open for 5 years you can also withdraw the growth, which is income tax and penalty-free

Benefits

Drawbacks

  • You can withdraw your contributions at any time tax-free and without penalty

  • After five years, you can withdraw the growth tax-free and without penalty 

  • Those who anticipate a higher rate of tax in the future benefit from a Roth
  • No required minimum distributions for Roth account owners
  • No tax deduction on the front end
  • Before the age of 59.5, there is a 10% withdrawal penalty if the five year hold period is not met and/or the withdrawal is not qualified
  • High earners cannot contribute to a Roth; for 2021, that's anyone earning over $140,000 as an individual or $208,000 as a married couple

Can my employer contribute to my IRA?

You may be able to maximize your IRA contributions in other ways, namely if your employer offers an IRA matching program. There are three common IRA options that can be set up by an employer

  • Payroll Deduction IRA: Your IRA contributions come out of your paycheck automatically via payroll deduction.
  • SEP:  Simplified Employee Pension plans are ideal for self-employed people and small business owners. A SEP IRA allows employers of any size to contribute to their employee plans and receive a tax deduction.
  • SIMPLE IRA Plan: Savings Incentive Match Plans let employees choose to make a salary reduction contribution, while the employer makes a matching contribution.

Before 1997, a SARSEP (Salary Reduction Simplified Employee Pension) IRA allowed employees to make pre-tax contributions to IRAs through salary reduction; however, this type is no longer available.

Reach out to your human resources person and/or your financial advisor to find out of any of these employer IRAs are available to you. Note that not all employers offer such options.

With all that in mind, a big question remains: should you invest in an IRA?

Why should I invest in an IRA?

Investing in an IRA is investing in your future. Even if you already have other retirement plans like a 401(k) or a pension, an IRA is an additional source of funding. The earlier you start your IRA contributions, the more funds you’ll have during your retirement.

Consider opening and contributing to whichever IRA best suits your financial needs. First Republic Bank offers IRA options to help you save for the retirement you deserve.

 

The strategies mentioned in this article may have tax and legal consequences; therefore, you should consult your own attorneys and/or tax advisors to understand the tax and legal consequences of any strategies mentioned in this document. This information is governed by our Terms and Conditions of Use.