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What Is An Individual Retirement Account (IRA)?

By Edited Aug 27, 2015 1 0
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One of the primary mistakes people make with money is to assume that money management is something reserved for rich people. Just because you don't spend weekends on a yacht or have bespoke suits that cost a few thousand dollars a piece doesn't mean your money is any less capable of picking up a shovel and getting down to business. If you don't have a lot of Benjamins to order around though it's important to understand the tools you have at your disposal.

If you're planning for retirement, then one of the best tools you can use is an Individual Retirement Account, also called an IRA.

What Is An IRA?

The short explanation is that an IRA is a savings account where you keep your retirement savings. You go down to your local bank and tell them you'd like to open an account, you put some cash into it, and then every paycheck you set a little bit of money aside and put it into the IRA so it will be waiting for you when you retire. Once the money is in you can't take it back out without a penalty until you reach retirement age either, so it's important to remember that this piggy bank has teeth if you hit an emergency.

That sounds like a raw deal to most people; after all why open an account where you can't take your money out whenever you want? Well, IRAs come with other features that make them useful. For instance, they typically have notably higher rates of interest which will help your money grow a lot faster than it would if you were just tossing it into a generic savings account. Also, all deposits up to a certain yearly limit are tax deductible.

You read that correctly. As far as the government is concerned using an IRA to plan your retirement is treated the same as if you gave that cash to charity.

Rules and Restrictions

An IRA is not a one-size-fits-all ordeal either. There are traditional IRAs, SEP IRAs, Simple IRAs, and Roth IRAs. Traditional IRAs take money before you pay taxes on it, and thus you have to pay taxes when you withdraw it. SEP IRAs are for self-employed or freelance workers. Simple IRAs are aimed at small businesses, and they act as a matching plan for employers and employees. A Roth IRA protects all of the interest and gains earned from taxes, which means that no matter how much the money grows the owner never pays taxes while it's left in the account.

If that looks confusing, that's because it is. A simpler explanation is that there are restrictions on what kind of IRA accounts you can have. If you're self-employed or a freelancer, if you have other kinds of retirement accounts like a 401k through your employer then you may not have access to a given kind of account. The easiest way to figure out your options is to go down to your bank and find out what kinds of accounts you have access to, and what benefits it will provide.

A Perfectly Legal Tax Shelter

While the benefits of setting aside cash for your retirement are obvious, the main bonus of an IRA is that it acts as a perfectly legal tax shelter. If you are making money hand over fist (because we're using the power of our imaginations here) and you want to pay less in taxes then all you need to do is sock some of that cash into an IRA. While it's in that account the money is safe, and you pay less in taxes that year. You still have the money, but you've set it aside for later. This is one of the best tricks used by financial planners for those who want to reap the benefits of investing money, but who want as little risk as possible.

Other Money Articles

If you enjoyed this quick and easy explanation of what an IRA is and how it works then you should also check out this article which explains what the gold standard is, and why we no longer use it in the modern day.

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Bibliography

  1. "What Is An IRA Account and How Does It Work?." eHow. 21/12/2014 <Web >
  2. "Basics of an IRA- Ultimate Guide To Retirement." CNN Money. 21/12/2014 <Web >

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