What Is an IRA and Should You Contribute to One?

If you're making plans to save for retirement, it makes sense to take advantage of generous tax breaks. There are different kinds of accounts in which you can make tax deductible investments, which effectively amounts to the government subsidizing your retirement savings. IRAs are among those types of accounts.

What is an IRA?

While many people think IRA stands for Individual Retirement Account, it actually stands for Individual Retirement Arrangement. IRAs are special investment accounts you can open with any financial institution. What distinguishes IRAs from other accounts is that you may be allowed to take a tax deduction for some contributions you make to the account.

There are actually several different types of Individual Retirement Arrangements you can get tax breaks for investing in. These include:

• Traditional IRAs: Traditional IRAs are open to employees and the self-employed. You can contribute up to $5,500 annually as of 2018, provided your income isn't too high. If you're over the age of 50, you're eligible to make an additional $1,000 catch-up contribution, bringing your maximum total tax-deductible investment to $6,500. You deduct contributions from your taxable income in the year you make the contributions, which means you don't pay federal taxes on money you contribute.
• Roth IRAs: Roth IRAs are also open to employees and the self-employed. Contribution limits are the same as for traditional IRAs, and in fact, while you can contribute to both a traditional and Roth IRA, these accounts have a combined contribution limit. That means you have up to $5,500 (or $6,500) total to contribute to both accounts. The big difference between Roth and traditional IRAs is the tax break comes later with the Roth -- you contribute with after-tax dollars but can withdraw money tax-free during retirement.
• SEP IRAs: SEP IRAs allow businesses to make contributions to employee retirement accounts. If you're self-employed, you can contribute to a SEP even if you operate as a sole proprietor and don't have a separate employer. Contribution limits as of 2018 equal the lesser of $55,000 or 25% of compensation. Contributions are made with pre-tax funds, just like with a traditional IRA.
• SIMPLE IRAs: These are also set up to facilitate business contributions to retirement savings. Both employers and employees can make contributions. Employees can contribute up to $12,500, and if the plan permits, those who are 50 and over can make up to $3,000 in additional catch-up contributions. Depending how the plan is set up, employers may be required to match up to 3% of the contributions eligible employees make. And, like a SEP and traditional IRA, contributions are made with pre-tax funds.

Unless your employer opens an IRA for you, you can open your IRA with almost any financial institution. This includes brokerages, banks, and credit unions. You'll need to first open the IRA -- selecting the right type -- then transfer money in if you want to contribute to an IRA.

Should you contribute to one?

Whether you should contribute to an IRA depends on your personal financial situation. You should always contribute to an employer 401(k) first, if one is available and your employer matches contributions. Putting your money into a 401(k) to earn an employer match is a top priority because the employer match is free money -- plus you get the same tax breaks for 401(k) contributions as you get for contributing to an IRA.

Once you've maxed out the match, you may want to continue contributing to your 401(k) until you hit the contribution limit of $18,500 in 2018 (or $24,500 with catch-up contributions). Contributing only to a 401(k) makes life easier since you'll have just one account to manage and all contributions can be made directly from your paycheck before your money is taxed.

However, some 401(k)s charge high fees or have limited investment options. If yours does, once you max out your employer match, any additional contributions to retirement savings should typically be made to an IRA. An IRA will give you freedom to invest in almost anything you'd like, and you shouldn't pay any fees for the account.

Finally, if your 401(k) is a good one, and you max it out, consider opening an IRA to make additional pre-tax retirement contributions to bolster your savings and take advantage of all of the tax breaks you can.

Make sure you're eligible for the benefits of an IRA

Contributing to an IRA makes a lot of sense because you get a generous tax break. If you max out your IRA and make the full $5,500 in contributions when you're under 50, you'd save $1,210 on your federal tax bill if you were in the 22% tax bracket. Although you'd put away $5,500 for your future, your actual take-home income would be reduced by just $4,290 because of the tax savings.

Unfortunately, not everyone is eligible to get the benefits of contributing to a traditional or Roth IRA. For Roth IRAs, you may become entirely ineligible to contribute if your income is too high. For traditional IRAs, contributions are still allowed, but you can't deduct them if your income is above set thresholds. The income limits at which contributions start to get affected differ for traditional or Roth IRAs, and with a traditional IRA, income limits vary depending on whether you or your spouse is covered by a workplace retirement plan. The table below shows applicable limits.

Regardless of income, contributing to a SEP or Simple IRA is still an option -- but only if you run a business, earn self-employment income, or are offered the opportunity to make Simple IRA contributions by an employer.

Start making your IRA contributions today

If you're eligible and it makes sense for you to contribute to an IRA, don't hesitate to get started. Open an IRA with a brokerage or financial institution of your choosing today, and start investing. You still have time to max out your contributions for 2018, and when you're a financially secure senior, you'll be very glad you took action now.

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