First off, an IRA (Individual Retirement Arrangement) is NOT an investment.
An IRA is a shelter for investments. A tax shelter.
In an IRA, you can buy stocks, bonds, mutual funds, money market accounts, CDs, and, in some cases, real estate.
The purpose of using an IRA as an investment account to hold all of these securities is simple; the tax breaks. However, you are responsible for a 10% fee when you don’t follow the rules. The main rule to know is that, in typical circumstances, you should not begin pulling money out of an IRA until you are at least 59 1/2; otherwise, you could be hit with penalties and fees for the withdrawal. There are some circumstances when you can pull the money out early.
Note: You will not incur fees or penalties for withdrawing money that you put in, you will only incur fees or penalties from your earnings.
There are 2 common types of IRAs: a Traditional IRA and a Roth Ira. What’s the difference?
Traditional IRA vs. Roth IRA
Basically, there is one main difference. Traditional IRAs allow you to contribute pre-tax income. This means that you can put money in a Traditional IRA before Uncle Sam has the chance to touch it.
With a Roth IRA, you contribute taxed income. Here’s the catch: when you go to withdraw your money, in retirement, the withdrawals from a Traditional IRA are taxed and the withdrawals from a Roth IRA are tax-free (since you already paid tax on the money you put in). So in a Roth, you do not pay taxes on the capital gains you earn over the life of the account.
Isn’t the Choice Obvious?
The choice seems obvious, right? If you know anything about compound interest, then you know a Roth IRA would save you a lot more tax dollars than a Traditional IRA because you will generally make way more money through capital gains than you would contribute. Well, unfortunately, the government knows that too, so they put certain restrictions on Roth IRAs.
Example: if your income is too high ($191,000/year as of 2014), then you can’t contribute to a Roth at all. You can still contribute to a Traditional IRA, no matter how high your income, but the tax benefits decrease as your income increases.
Limits and Catching Up
If you are 50 or older, you can “catch up” on your investments in an IRA because you are allowed to invest an additional $1000 on top of the regular annual limit.
What annual limit, you say?
The maximum annual contribution limit in both types of IRAs changes almost every year, so look it up when you start an IRA.
Where to Open an IRA
You can open them at most financial institutions. This includes banks, investment companies, and many websites. Watch out, though, because some banks limit the types of investments that you can put in your IRA. Personally, I use Vanguard. I like their funds, customer service and the ease of opening accounts with them.
Pretty much any major investment firm can set you up with an IRA. The important thing is that you just go do it! Start investing now. Even a small amount every month is better than nothing and you may be pleasantly surprised at what your small monthly contribution can turn into.