The simplest way to explain an IRA would be to say that it is a retirement account that provides tax advantages. IRA stands for Individual Retirement Account. A lot of people may view an IRA as an investment but this isn’t really correct; it would be better to say that an Individual Retirement Account is a basket where you can hold your investments. This type of account covers a wide range of possibilities and the one you will choose will very much depend on your exact needs.
How IRA Works
The way an IRA works will depend on the exact type. The traditional Individual Retirement Account allows you to contribute anything up to $4000 each year and you won’t have to pay tax on this amount. In order to qualify for the traditional IRA though you will need to be at least 50 years old. When we say that this type of account is tax deductable we mean that you will be able to deduct the amount you put in your IRA from your yearly income; thus ensuring that you pay less tax. If you were to remove this money though it would then become subject to income tax. In fact if you withdraw the money before you reach sixty years of age (before 59 ½ years old to be exact) you will need to pay an additional penalty of 10% of the amount you withdraw. There may be certain circumstances where you can escape this penalty; for instance if you wish to purchase a home or pay for your child’s further education.
As well as the traditional Individual Retirement Account there are also other options and one of the most popular of these is the Roth IRA. This type of account is not tax deductable but it is exempt from many taxes. The way that the Roth works is that instead of getting tax deductions during the year of saving the money there is a tax break provided during retirement when the money is to be withdrawn. This type of IRA isn’t suitable for everyone but it is particularly liked by the middle classes.
There are also other Individual Retirement Account’s such as the SEP IRA where the employer is able to put money into the account; this is usually instead of a pension fund. A self directed IRA is an account where directions are given to make certain investments with the money in the account. A SIMPLE IRA is where both the individual and their employer can put money in the account and this will later be used as the basis for retirement income.
How to Choose an IRA
Choosing an IRA can be difficult because there are a few options. In order to make the best decision it is often advisable to seek the opinion of an expert; a financial planner can be ideal for this type of advice. It is important to understand the limitations as well as the advantageous of any Individual Retirement Account you are considering. If you pay money into this type of account but find that you need to withdraw it again before retirement you may end up paying a high price.