An Individual Retirement Account, or IRA, is a retirement investment tool that provides certain tax advantages, depending on the type in which you invest. Specific rules on contributions and disbursements apply to the different types of IRAs and certain classes of assets are not allowable in an IRA account.
Individual Retirement Accounts have been available to investors since the enactment in 1974 of the Employee Retirement Income Security Act. Over the years, additional acts of Congress have increased the limits on annual contributions, expanded the number of Americans eligible to participate and created additional types of IRAs.
The emergence of the IRA as a legitimate retirement investment vehicle affords you the opportunity to reduce your tax burden while saving for the future. Depending on which type of IRA in which you are investing, you may be able to reduce your annual income tax now or you may continue paying taxes on your current income and defer the tax savings until your retirement when you begin receiving disbursements from the IRA account.
Five types if IRA accounts exist, each with their own benefits or rules. The original, or traditional IRA, allows investors to contribute an annual amount and reduce their income tax burden each year they make a deposit. The Roth IRA allows you to contribute an annual amount with the tax savings deferred until you begin taking disbursements upon retirement. A SEP IRA is a traditional IRA the self-employed or small business owners can use in place of a company pension plan. The fourth type of IRA is the SIMPLE IRA, which is similar to a 401(k), except that it is easier for a company to administer--hence the name "SIMPLE." The final type of IRA account is the Self-Directed IRA, which includes a greater range of investment options, including real estate or business partnerships.
As with any investment, some amount of risk is involved with IRAs, depending on the type in which you are investing. Virtually every financial institution offers IRAs as an investment option and many offer several options from which to choose. You can find IRAs that are low-risk, with stated interest rates, that are similar to long-term certificates of deposit, or you could choose an IRA that will invest your contributions in securities, such as mutual funds, that include a higher level of risk.
Of course, the obvious benefit to an IRA is the savings you will accumulate over a long period. But don't overlook the tax benefits. Whether you choose to invest in a traditional IRA and keep more of your money from Uncle Sam now, or choose a Roth IRA so you will pay less in taxes when you are on a more fixed income in retirement, the tax savings is by far the No. 1 benefit of any IRA. Some investors have both a traditional and a Roth IRA, so they can enjoy a little of those tax advantages now, and a little more later.
Early withdrawals from an Individual Retirement Account are taxable, washing away any tax savings you might have enjoyed from making the contribution. Many financial institutions also will tack on an early-withdrawal penalty, as well. Before you contribute to your IRA, make sure you can afford to invest those dollars for the long-term.