How Does an IRA Work?

An IRA can help you create the financial security for your dream retirement. Photo source: Flickr user Pug50.

The majority of Americans don't save as much for retirement as they should, and if you're in this group, an IRA could be the best way to get on track. But too many people don't understand what an IRA is, how to open one, and how these excellent accounts work. If you've been thinking about getting serious about retirement savings, here's a primer on IRAs.

What is an IRA?IRA, which stands for "Individual Retirement Arrangement," is a tax-advantaged account designed to help people save and invest for their retirement. Many banks and brokerages offer IRAs, and they take several forms.

For example, there are IRAs that are essentially tax-advantaged savings accounts, with cash-equivalent investment options such as CDs and money market funds. Then, there are self-directed brokerage IRAs, where account holders choose their own investments and allocate their money as they see fit. Or, for those who prefer to leave their investments to professionals, there are full-service brokerage IRAs, where a financial advisor helps to construct a portfolio.

Traditional vs. RothThere are two main types of IRAs that are available to most people -- traditional and Roth.

A traditional IRA is a "pre-tax" account, meaning that you might be able to deduct your contributions from your taxable income depending on your income and whether you can participate in a retirement plan at work. Your investments are allowed to grow and compound on a tax-deferred basis, so you won't have to pay capital gains and dividend taxes year after year. Once you withdraw the money, it's treated as income and may be taxable.

On the other hand, a Roth IRA is an "after-tax" account, so you don't get a tax deduction for Roth contributions. However, your investments will grow and compound until your retirement, and any qualified withdrawals are 100% tax-free. So the biggest difference between the two types of IRAs is when you get the tax benefit -- now (traditional) or later (Roth).

Roth IRAs have a few other advantages. For one thing, you're free to withdraw your original contributions (but not any investment profits) at any time, for any reason. This effectively makes a Roth IRA a retirement savings account and an emergency fund. Roth accounts also have no required minimum distribution (RMD) requirement, no matter how old you are.

Contribution limits and eligibilityThe limits change over time, but for the 2016 tax year, you can contribute a maximum of $5,500 to your IRA. If you're 50 or older, you're allowed an additional $1,000 "catch up" contribution as well.

Contributions can be made until 2016's tax deadline April 15, 2017. Keep in mind that this limit still applies if you have more than one IRA. For example, if you have both a Roth and traditional IRA, your total contributions for 2016 can't exceed $5,500 ($6,500 if over 50).

Everyone is eligible to contribute to a traditional IRA, but as I mentioned before, there are certain requirements related to your income and eligibility to participate in a plan at work to be eligible to deduct your contributions.

The ability to contribute directly to a Roth IRA is subject to income limitations. For 2016, your ability to make a full Roth contribution begins to phase out at adjusted gross income (AGI) of $117,000 (single) or $184,000 (married) and goes away completely at AGI of $132,000 or $194,000.

It's also worth noting that these limits only apply to direct Roth contributions. Anyone can contribute to a traditional IRA and then convert the account to a Roth a strategy known as the "backdoor" method of contributing to an IRA.

When can you withdraw your money?The short answer to when you can withdraw your money is age 59 1/2. This is considered to be full retirement age for IRA purposes, and you can withdraw from your account for any reason after you reach this age. And, as I mentioned earlier, you can withdraw your Roth IRA contributions at any time, and for any reason.

Having said that, there are a few situations where you can withdraw from your IRA early. One common exception is the ability to withdraw up to $10,000 to be used toward a first-time home purchase for you or a loved one. Also, you can withdraw any amount at any time to be used for qualified higher-education expenses, or if you become disabled.

One popular misconception is that IRA account holders can take a loan against their account, and this is 100% false. While loans are allowed with some other types of retirement plans, such as a 401(k), there is no such thing as an IRA loan.

When do you have to start withdrawing your money?When you have to start withdrawing your money depends on the type of IRA you have. As I mentioned earlier, Roth IRAs have no minimum distribution requirements, no matter how old you get.

On the other hand, a traditional IRA (and most other pre-tax retirement accounts) require that withdrawals are started by the year in which the account holder turns 70 1/2. Beyond this point, a certain percentage of the account must be withdrawn every year, as determined by IRS life expectancy tables.

Investment optionsOnce you contribute to an IRA, you literally have thousands of investment options, which can seem overwhelming to a new investor. You can choose any stocks, bonds, or funds you'd like, or you can keep some of the money in cash, CDs, or money market accounts.

If you have the time and interest, individual stocks can be a great way to take an active role in your retirement planning. Here's a example of some great retirement stocks from our contributors that can help you get started. On the other hand, if you don't want to pick stocks, or simply don't have the time to research stocks properly, there's nothing wrong with investing in funds and essentially putting your investment portfolio on auto-pilot.

Another potential tax benefitIf you're a low- to moderate-income worker, there may be an additional tax benefit for you, known as the Retirement Savings Contributions Credit, or Saver's Credit. Based on your income and marital status, this credit could give you up to $1,000 per year just for saving for your retirement. So if your AGI is less than $61,500 (married) or $30,750 (single), this is definitely worth looking into.

The bottom line on IRAsAs a final thought, consider that if you contribute $5,500 to an IRA each year for 30 years, and your investments earn returns at the stock market's historical average, you could be sitting on a nest egg of more than $820,000 at the end of that time. Just think about what that sum of money could mean to your financial security in retirement. The bottom line is that an IRA is an excellent way to set yourself up for the retirement of your dreams, while reducing your taxable income at the same time -- either for now or later.

The article How Does an IRA Work? originally appeared on Fool.com.

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