An individual retirement account (IRA) is a special type of account that has specific tax benefits. IRAs were authorized by the U.S. Congress as part of the 1974 Employee Retirement Income Security Act to provide taxpayers who were not covered by a qualified retirement plan with a means of setting aside a portion of their earnings in a tax advantaged account. You can use funds in your IRA to purchase a wide variety of investments, including shares of stock and bank certificates of deposit.
An individual retirement account is a special type of trust or custodial account that may be best described as a holding account. The IRA account itself is not an investment. It is an account that holds your investments. You can only open an IRA account with a financial institution that meets Internal Revenue Service (IRS) approval, such as a bank, insurance company, mutual fund company or investments brokerage firm, and you can only fund your IRA account with money. You can then use the money in your IRA account to purchase investments and securities.
Types of IRAs
The IRS recognizes two primary types of IRAs: traditional IRAs and Roth IRAs. Each has similar, but distinct, tax advantages. Contributions to a traditional IRA are tax deductible, while contributions to a Roth IRA are not. Qualified withdrawals from a traditional IRA are treated as taxable income while qualified withdrawals from a Roth IRA are free from federal income taxes. Funds inside either type of IRA are allowed to grow without creating a taxable event.
You may use funds in your IRA to purchase a bank certificate of deposit. A CD held in your IRA performs the same as a CD held outside your IRA. The only difference is the interest generated by the CD is not subject to current income taxation. CDs offered by banks that are insured by the Federal Deposit Insurance Corporation are considered among the safest of all investments, since both principal and interest are insured up to the maximum allowed by law. Once the CD matures you can re-invest the proceeds into another CD or into another type of security.
You may use funds in your IRA to purchase shares of individual stocks or mutual fund shares. The dividends generated by these shares and any capital gains or losses resulting from the sale of these shares do not result in a taxable event. Your investment in shares of stock or mutual fund shares inside your IRA respond the same as they would outside of the IRA, except for the tax deferred feature. Investments in shares of stock or mutual funds involve a higher level of risk than a similar investment in a bank CD, but may also offer a higher level of return on investment. Equity investments, such as shares of stock and mutual funds, are not insured by the FDIC or any other federal agency, even if an FDIC-insured bank acts as the custodian of your IRA.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.