What is an IRA, and how does it work?

James Viceconte, Head of Investment Product | Citizens Wealth Management

James joined Citizens Wealth Management in 2022 and is responsible for the curation and management of the investment product suite of ETFs and Mutual Funds, and portfolio models constructed with these products. As a strategic partner, he has over 30 years of experience in financial markets focused on a broad array of public and private equity and fixed income products.

There are several ways to go about planning for retirement, but a popular option to complement your employer-sponsored plan is investing in an IRA. Like 401(k)s, IRAs come with tax advantages that encourage you to put money in an account that has an opportunity for growth until you need to withdraw it for retirement income.

Let's explore the different kinds of IRAs and their details and benefits to help you decide if investing in one is right for you.

IRAs explained

Individual retirement accounts (IRA)s are designed to help people plan for retirement outside of and in addition to employer-sponsored plans. Anyone with earned income can open an IRA at any financial institution that offers them. You'll usually find competitive options at banks, credit unions, investment companies and brokers.

Some places will have a required minimum initial deposit. Once you've opened the IRA, you can contribute as often and as much as you want up to the annual contribution limit — in 2024, the yearly maximum is $7,000 for people younger than 50 and $8,000 for people 50 and older. You may find it helpful to set up regular automatic contributions so you don't forget to put money in.

IRAs are popular in part because you'll likely have more investment options than with an employer-sponsored plan. You'll likely be able to choose from a variety of stocks, bonds, CDs, Treasuries, mutual funds, exchange-traded funds (ETF)s and more. If you don't want to be very hands-on, you may be able to simplify by selecting a target date fund in line with your expected retirement year that has a pre-made mix of investment types.

Benefits of an IRA

IRAs are designed for long-term saving, so they come with advantages to encourage investors to use them. Here are the top benefits of maintaining an IRA either on its own or as a supplement to your employer retirement plan:

Tax advantages

This is the main draw of IRAs over other savings and investment accounts. You have two options, and both have perks. With a traditional IRA, you avoid paying taxes now in favor of paying them when you withdraw money later, ideally after age 59½ so you don't trigger a 10% tax penalty. With a Roth IRA, you pay taxes on your contributions now and then potentially take out withdrawals tax-free in retirement.

Long-term investment potential

As a long-term savings tool, IRAs hold a lot of growth potential, especially if you start saving early. While the market can be volatile in the short term, it broadly tends toward a positive return over time. When you're putting away money for decades, you can give it time in investments to grow and rebound from dips in the market.

Compounded earnings

The earnings from interest or investment gains in an IRA will compound, meaning they'll be folded back into your investment and eligible to grow again.

Control over investment options and provider

With employer plans, you're limited to the investment choices they offer, and if you leave your job, you usually have to move the account funds elsewhere. IRAs tend to have a wide range of investment options, and you can keep it at one institution as long as you like or roll it elsewhere if you find more competitive features.

Types of IRAs

Depending on your circumstances, you may have a few types of IRAs available to you. The choices may depend on your income and whether you're using an IRA to save as a self-employed person or an employee of a small business.

• Traditional IRAs. Anyone with earned income can open a traditional IRA, the contributions for which may be tax deductible and grow tax-deferred.
• Roth IRAs. With Roth IRAs, you pay taxes on your contributions upfront but have the opportunity for tax-free growth and tax-free withdrawals later. If you have a high income, you may not be able to contribute to a Roth IRA. The IRS limits this specially advantaged account to anyone with a modified adjusted gross income of less than $161,000 for single taxpayers and $240,000 for joint taxpayers.
• SEP IRAs. Simplified employee pension IRAs are designed for self-employed workers and small business owners. Contributions are made only by the employer and cannot be more than 25% of the employee's pay or $69,000 per year, whichever is less.
• SIMPLE IRAs. A savings incentive match plan for employees is an option small-business employers (having fewer than 100 employees) may offer. Both employees and employers can contribute to SIMPLE IRAs. Employees can put away up to $16,000 per year if they're younger than 50 or $19,500 if they're 50 or older.
• Bank IRA savings or IRA CDs. These savings accounts and CDs are held in tax-advantaged IRA accounts, but the contributions collect interest rather than being invested. They are considered less risky than brokerage IRAs but are sure to have a positive, though smaller, earning potential

Using an IRA to prepare for your retirement

When thinking about your retirement years, consider all the potential sources of your retirement income. You might have a pension or a 401(k), plus you'll likely have some Social Security benefits, and you may have IRA and other investment funds. It's important to think about how these income sources will coordinate to provide you with the standard of living you expect to have during retirement — and how you'll fund them to be ready. For instance, employer-sponsored plans often have much higher annual contribution limits, but if the investment choices are too limited, it may be worth diverting some of your savings to an IRA where you'll have more options and control. It's also wise to consider tax efficiency. Your tax bracket now vs. your tax bracket later may change, and it could be a smart idea to split up your tax liability between a Roth IRA that taxes you now and a traditional 401(k) and IRA that tax you later.

IRA FAQs

Can I contribute to both a 401(k) and an IRA? 

Yes, you can contribute to a 401(k) and an IRA up to the annual contribution limits for each.

Can I have multiple IRAs?

Yes, you can have multiple IRAs. Keep in mind that IRA annual contribution limits apply to the combination of all your IRAs.

What is a rollover IRA?

A rollover IRA holds funds from a previous employer-sponsored plan like a 401(k) without triggering a penalty or tax. You will typically roll over employer contributions in kind to the type of IRA you opened. For example, pre-tax rollovers will typically go to a traditional IRA, and post-tax rollovers will go to a Roth IRA. 

What happens to an IRA if I inherit it?

It depends on your relationship to the original account holder and the type of IRA. You may be able to treat it as your own, or you may be required to withdraw all the assets within 10 years. A tax professional or financial advisor can help you understand the tax implications.

Explore strategies for saving for your future

With an understanding of what an IRA is, how they work and the different types available, you can get started on deciding which may be right to include in your strategy. Whatever you choose, it's important to start planning for retirement early and contribute often so you can tap into the benefits of long-term investing and compound earnings.

Ready to open an IRA and start saving? Request a call from a Citizens Wealth Advisor to help you prepare for the road ahead.

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