How does an IRA work?

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by daniela , in category: Banking and Credit , 10 months ago

How does an IRA work?

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1 answer

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by andy , 10 months ago

@daniela 

An Individual Retirement Account (IRA) is a type of investment account that provides tax advantages for retirement savings. Here's a general overview of how an IRA works:

  1. Account holder: An individual establishes an IRA account in their name. They can contribute to it themselves or have contributions made on their behalf, such as through an employer-sponsored retirement plan or a spouse's IRA.
  2. Contribution limits: There are annual contribution limits set by the IRS for traditional and Roth IRAs. As of 2021, the limit is $6,000 per year for individuals below the age of 50 and $7,000 per year for individuals aged 50 and older (catch-up contribution).
  3. Traditional IRA: Contributions to a traditional IRA may be tax-deductible, meaning they reduce the individual's taxable income in the year of contribution. The earnings within the account grow tax-deferred until withdrawal. The withdrawals in retirement are subject to income tax.
  4. Roth IRA: Contributions to a Roth IRA are made with post-tax dollars, so they are not tax-deductible. However, the earnings within the account grow tax-free, and qualified withdrawals in retirement are tax-free. Roth IRAs have income limits for eligibility.
  5. Investment options: IRA funds can be invested in various financial instruments like stocks, bonds, mutual funds, ETFs, and more. The specific investment options depend on the financial institution holding the IRA account.
  6. Tax advantages: Both traditional and Roth IRAs offer tax advantages. Traditional IRA contributions may be tax-deductible, while Roth IRA contributions are not deductible but provide tax-free growth and withdrawals in retirement.
  7. Withdrawals: IRA withdrawals can generally be made penalty-free after reaching the age of 59½. However, traditional IRA withdrawals are subject to income tax, while qualified Roth IRA withdrawals are tax-free.
  8. Required Minimum Distributions (RMDs): Traditional IRAs require individuals to start taking RMDs from their accounts by the age of 72 (as of 2021). RMDs are taxable and help ensure individuals use their retirement savings during their lifetime.


It's important to note that IRA rules can be complex and may differ based on an individual's unique circumstances and specific IRA type. Consulting with a financial advisor or tax professional can provide personalized guidance on how an IRA works for your individual situation.