What is an IRA? What are the different types of IRAs, and what do the different terminologies mean? People have a lot of general questions about IRAs, and in this article, we are going to try to provide a few answers to these FAQs.
IRA Definition | Get Straight Answers To Questions
In this article:
- What Is an IRA?
- What Is the Purpose of an IRA?
- What Are The Different Types of IRAs?
- What Is a Modified Adjusted Gross Income?
- What Is a Contribution Limit?
- How Is IRA Different from Other Forms of Investments?
What Is an IRA?
The IRA definition is this: it stands for an individual retirement account. From this, we can break it down into the following:
- It is an account, which you can open in banks, brokerage, and other financial institutions.
- Its main purpose is to build your retirement fund.
- It is for individuals, which means couples can have separate accounts. Families can also open one for their children as long as they’re earning an official income (which means paying for washing the dishes doesn’t count).
- It is separate from the retirement plans offered by companies, although these businesses can still have an IRA account called SEP (Simplified Employee Pension) IRA. Employees can also contribute with a SIMPLE IRA.
What Is the Purpose of an IRA?
As mentioned in the earlier IRA definition, its primary objective is to build or provide more ways to increase your retirement nest egg. People who reach their retirement age, defined as 66 years old in order to receive full Social Security benefits, have the option to use their savings to buy a house, travel the world, invest or even pass on to their children as a form of inheritance. The goal is it save and invest now so you can benefit later.
To encourage people to save in an IRA account, the government provides attractive tax advantages. In some ways, the IRA can also be a tool to create more money without the burden of potentially paying more in taxes.
What Are The Different Types of IRAs?
Inside Your IRA has already covered some of the common kinds of IRAs you can choose. I will provide you with the basics for some of the most popular:
- Traditional IRA – Established in the 1970s, this is the first IRA. It allows you to reduce your taxes by deducting your contributions. You can also defer paying taxes on your earnings until you withdraw the money. The mandatory age for taking distributions is 70.5 years old.
- Roth IRA – Established in the 1997, this is the closest “competitor” of the Traditional IRA. It is an account you fund with post-tax income. As such, you cannot claim deductions on contributions, but your savings are already tax-free. You can also avoid paying taxes for your earnings and withdrawals as long as you follow the rules.
- SIMPLE IRA – This is a type of Traditional IRA that is ideal for self-employed individuals and small businesses. It is a match plan, which means both the employers and the employees contribute to the account.
- SEP IRA – This IRA is very similar to SIMPLE IRAs. It is also a Traditional IRA, but it differs in terms of contribution limits.
- Spousal IRA – This is a kind of IRA that allows a spouse who has limited or zero income to open and build a retirement account. The other spouse contributes on his or her behalf.
What Is a Modified Adjusted Gross Income?
Income plays a huge role in the IRA definition. It determines your eligibility and contribution limits, for example. But when one says “income,” many people think it relates to their wages or their taxable income.
When it comes to IRA, it depends on the modified adjusted gross income (MAGI), which is different from the adjusted gross income (AGI). Essentially, AGI refers to your annual income less allowable adjustments or deductions, including your IRA contributions. It is mainly for tax purposes. MAGI, on the other hand, is AGI plus other adjustments such as interest on student loans, IRA contributions, and rental losses. While MAGI may be higher than AGI, it’s also possible for them to be the same. It simply depends on your individual finances.
What Is a Contribution Limit?
Contribution limits refer to the maximum amount of money you can place in your retirement account. The purpose for this is to prevent wealthy individuals from using this plan to avoid paying the right taxes. For both Traditional and Roth IRAs, they are the same. People who are below 50 years old can contribute $5,500. Those who are 50 years old and above can make an additional catch-up contribution of $1,000, which means they can put as much as $6,500 into their account.
How Is an IRA Different from Other Forms of Investments?
This question is actually tricky. Although the IRA definition states it is a form of a retirement account, in reality, you’re investing the money in different portfolios. These include common options like stocks and mutual funds, and also alternative assets, such as real estate and precious metals. This way, even if you have a limited contribution, you can still grow your money.
Your IRA is primarily for retirement, which means you cannot withdraw from it any time you like unless you want to pay a penalty. Regular investments are much easier to withdraw or liquidate.
Another consideration is the tax benefits. Some investments may require you to pay taxes while with IRA earnings can be tax-free or deferred until you withdraw. In the process, it allows the earnings to grow.
We get it. Just hearing those three letters “IRA” can seem overwhelming or complicated to understand and makes people cringe or shy away from learning more. But hopefully, this article has helped to provide a simple breakdown of a few FAQs surrounding IRAs. So while it can seem like a looming monster, just remember that the more you know and the more you invest in your own knowledge of the options you have available to you, the more you will have the tools to effectively invest in your IRA.
Do you have more questions about the IRA definition? Please feel free to leave them in the comments below.