What is an IRA? Your Ultimate Guide

We all understand that it’s important to save for retirement, but knowing where to start and the various options available can be complicated—this includes knowing exactly what an IRA is and whether it’s the right choice for you.

What exactly is an IRA?

IRAs or individual retirement accounts (which also includes SEP, Simple, Roth, Solo 401(k)) are among the most popular savings tools available. Many investors find these tax-advantaged investment accounts attractive as they may help meet retirement savings goals more quickly than in a non-IRA account. They also allow for more investment options than an employer-sponsored plan. They were first made available to individuals in 1975 by the Internal Revenue Service (IRS) to provide individual investors a tax-advantaged avenue to save and invest for retirement.

So you further understand exactly what an IRA is, let’s review some retirement account characteristics, potential tax benefits, various types of IRAs, some differences between an IRA and a 401(k), and how to choose the right IRA for you.

How does an IRA work?

An IRA functions as an investment account with the potential to defer paying taxes on income and gains. The IRA itself is not the investment, but the holding account where you manage your positions in stocks, mutual funds, bonds, and private investments. The reward you seek should correspond with the level of risk you’re willing to take. One way to reduce your risk is to diversify. Higher risk investments, like stocks, may grow IRAs more quickly, while bonds may be more stable and tend to grow an IRA more slowly.

What are some benefits of an IRA?

The advantages of IRAs may include tax-deferred growth on earnings, the potential for reduced adjusted gross income (AGI), and in the case of a Roth IRA, the potential for tax-free growth of earnings. 

As an example, your tax-deductible IRA contributions may decrease your adjusted gross income. Keep in mind that your AGI is used as a qualifier for your tax rate. If your IRA contributions are significant enough in a given year, you may reduce your AGI so much that you could find yourself in a lower income bracket, which in turn could allow for additional itemized tax deductions. 

Here are a few other potential advantages of IRAs: 

• Learning about IRAs is important for understanding their key benefits and versatility. These benefits may enable you to reach your retirement goals faster—whether you’re personally controlling your investments or leaving the decisions to a professional. 
• Unlike a 401(k), which requires employer-sponsorship, IRAs are available to everyone (this includes the self-employed) to utilize during their working life to save for retirement.
• The majority of retirees are in lower tax brackets than they were when they were working. As a result, money ultimately may be taxed at a reduced rate thanks to the tax deferral. 

What happens to my IRA when I retire?

Knowing what happens to your IRA when you reach a certain year is just as important as knowing what an IRA is and how to utilize one. To avoid penalties, below are a few things to know:

Your money can’t sit in your IRA forever. Sorry, but if you’re planning on never withdrawing money from your IRA and just passing the totality on to your spouse or children, that isn’t going to happen due to congressionally mandated required minimum distributions (RMDs).Regardless of your employment status, once you reach 72 years of age, you’re required to begin withdrawing money from your account. This requirement is so that the IRS can tax money that was previously not taxed.

RMDs are different for different people. Not everyone’s retirement plan looks the same and not everyone has invested the same amount during their working years. Because of this, the amount individuals need to withdraw yearly will vary and depend on a variety of factors.

Not taking an RMD results in steep fines. It’s true, if you don’t withdraw your required minimum amount from your IRA, you’ll be fined. The penalty is a 50% tax on the amount of money that was not withdrawn in time. 

Different types of IRAs

Now that we’ve discussed what an IRA is, how an IRA works, and the primary benefits of having an IRA, it makes sense to dive into the different IRAs available to investors. Two important types of IRAs are Traditional and Roth IRAs. However, various subsets of these types of IRAs also exist. 

Traditional IRAs vs. Roth IRAs

At a high level, Traditional IRAs are open to income-earning individuals for as long as you have earned income. This type of IRA may provide a deduction for the tax year in which the contribution was made, as well as potentially having the earnings grow tax-deferred. However, when the owner of the account reaches 72 years old, withdrawals from the IRA generally begin and will be taxed.

Unlike Traditional IRAs, Roth IRA contributions are post-tax, meaning there is no available deduction. However, since you have already paid taxes on this money, Roth contributions are not taxed when withdrawn as long as you are at least 59 ½ years old. 

Traditional IRAs and Roth IRAs are governed by income thresholds that dictate who is eligible to contribute to the accounts. The combined annual contribution limit for 2022  for Roth and traditional IRAs is $6,000 if you are under age 50 or $7,000 if you’re age 50 or older, but in 2023 those numbers have increased to $6,500 and $7,500 respectively.

Put simply, with a Traditional IRA, you pay taxes on income and gains upon withdrawal, while Roth IRAs require you to pay the taxes upfront. You may get a break for the year of your contribution and your contributions grow tax-free. Because they’re taxed upfront, there are no RMDs applied to Roth IRAs.

When talking about Roth IRAs, it’s important to mention the existence of Backdoor Roth IRAs. The IRS prevents people of various income thresholds from funding a Roth IRA. But, technically there is no income limitation on Roth conversions from a 401(k) rollover or a Traditional IRA conversion to a Roth IRA. The Backdoor IRA is a way for those whose income exceeds the income limitations put in place by the IRS to still contribute to a Roth IRA. Though they are technically a legal way to circumvent these limitations, due to a tax loophole, Backdoor Roth IRAs are often a divisive topic and not recommended by all financial advisors. 

Here’s a quick breakdown of the other kinds of IRAs, including who could benefit from each kind.

Spousal IRA

A Spousal IRA can be either a Traditional IRA or a Roth IRA. In a Spousal IRA, a married taxpayer contributes money to fund an IRA for a spouse that makes less than $2,000 annually. From a tax perspective, the couple must file a joint return any year a contribution is made. 

Intended audience: Households where one spouse makes less than $2,000 per year and has a taxpaying spouse willing to fund a Spousal IRA. 

Self-Directed IRA 

Self-Directed IRAs (SDIRA) give an investor more control, with the ability to broadly diversify a portfolio’s holdings beyond securities such as stocks, bonds or mutual funds. If you have this type of IRA you may invest in properly registered exempt securities/alternative assets—provided you have a custodian or trustee that will hold the account for you. Be sure to check your state’s Blue Sky Laws, as well as consult with your tax or legal advisor.

Instead of just buying into a single real estate investment trust or REIT, you can invest in a multitude of properties, property liens, or other kinds of real estate investment vehicles. You can place money into real estate such as a vacant lot, a small parcel of land, or a dormant commercial property with future potential value.

Intended audience: Individuals that are seeking exposure to a broad universe of asset classes and are looking for the potential of non-correlated returns, exposure to private placements, and investments they can see feel and touch that are not related to the stock market.  

SEP IRA

A Simplified Employee Pension, also known as a SEP IRA, is an account set-up for small business owners that allows them to make a tax-deductible contribution for themselves and their employees into a Traditional IRA. 

Intended audience: Business owners looking to offer a retirement plan for employees and contract workers. 

SIMPLE IRA

A Savings Income Incentive Match Plan (SIMPLE) IRA is designed for small businesses to create individual accounts for individual participating employees. SIMPLE IRAs allow employers and employees to make contributions. 

Intended audience: Small business owners that want to make tax-deferred contributions to employee plans. 

Inherited IRAs

An Inherited, or Beneficiary IRA is a retirement account that has been left to a single person, multiple people, an estate, or a trust, once the original owner dies. If you are the only beneficiary of your spouse’s IRA, the account will be transferred to you and will be treated by the IRS as if it had been yours all along. However, it’s worth noting that this type of IRA can get a bit tricky if it involves multiple beneficiaries or a trust, as the taxes and required distributions depend on the relationship to the original owner and the type of IRA.

Intended audience: Beneficiaries of an IRA once the owner dies. 

Nondeductible IRA

Nondeductible IRAs are an option for individuals with income that is over the amount for the IRS to allow them to make tax-deductible contributions to a regular IRA. If you are using this as a retirement savings tool, plan to fund it with after-tax (non-qualified) dollars. Unfortunately, contributions to this type of IRA are nondeductible. 

Additionally, a contribution to a Traditional IRA is non-deductible when you are eligible to contribute to an employer 401(k) plan. This rule is to encourage participation in employer-sponsored retirement plans.

Intended audience: Individuals that generate too much income for the IRS to allow them to make a tax-deductible contribution to a regular IRA. 

What’s the difference between a 401(k) and an IRA?

Now that you have a strong grasp on what an IRA is, let’s take a look at the difference between an IRA and a 401(k). A 401(k) is another investment tool for individuals saving for retirement. So what’s the difference between a 401(k) and an IRA? Well, 401(k)s are set up and offered by employers, whereas IRAs are opened by individuals.

One key benefit of a 401(k) comes into play if your employer contributes to the account, commonly known as a company match. It’s a great way to maximize the amount you save, and essentially get money for free. 

Comparatively speaking, 401(k)s tend to be more restrictive from an investment perspective—both when it comes to costs and selection. An IRA, on the other hand, provides you with more control over your investments and more options. If deductible, this form of retirement savings also reduces your taxable income for that specific year. 

How do I set up an IRA?

Thanks to technology, IRAs can be opened online in just a few quick steps. To get started, you need to determine if you want to be a hands-on or hands-off investor, select an IRA that coincides with your investor persona, open the account itself, and get it funded. 

Hands-On Investor

If you’ve decided that you want to be a hands-on investor, it makes sense to select an online brokerage that enables you to personally buy and sell investments. 

Hands-Off Investor

For those that prefer to be hands-off and to leave it to the professionals, you’ll probably want to enlist a financial advisor to manage your investments and exercise diligence to help ensure that your growth goals are being considered based on time to retirement and financial needs. 

Middle-of-the-Road Investor

If you find yourself to be a middle-of-the-road investor, i.e. one that wants some control, but needs a little help with investments and meeting growth goals, consider a robo-advisor that will manage your portfolio and select funds for you. This can be a great way to save money compared to other financial advisors. 

Can I Invest with my IRA?

Investing with your IRA is absolutely an option, but there is more you’ll need to know. Below are a few key things to remember:

Investing with an IRA is possible, but only if it is a self-directed IRA.

Unlike Traditional IRAs and Roth IRAs, in which people often invest in stocks, CDs, mutual funds, cash, and bonds, self-directed IRAs allow you to invest in alternative assets that such as real estate.

Your IRA custodian must allow for alternative investments.

Investing in alternative assets can be a great way to diversify your portfolio, but you’ll need to first check to confirm that your IRA custodian allows for alternative investing. 

There are pros and cons to Self-Directed IRAs.

Though Self-Directed IRAs allow for greater flexibility in the types of investments you choose, you’ll also need to be more proactive in how your SDIRA is invested. Thanks to robo-advisors, Roth and Traditional IRAs are increasingly easy to set up, simply set your age, investment goals, and when you expect to retire. Not all custodians offer Self-Directed IRAs, so you’ll need to find one that works for you. Things to consider when searching for a custodian are: what asset classes/investments you’ll be allowed to take advantage of, fees associated with the IRA, and investor support in case you have questions. 

At the end of the day IRAs can be powerful tools to use when saving for retirement as their potential tax advantages may enable your funds to grow more quickly than taxable investment accounts. They are also accessible to everyone, regardless of employer participation. Take the time to research not only what type of IRA is right for you, but eligibility requirements, your investor persona, tax implications due to leverage, your state’s Blue Sky Laws, and the permissibility of the investment for your type of retirement account. As always, check with your tax or legal advisor for confirmation of your understanding of the effects of your investment before moving forward. 

Have additional questions regarding investing with your IRA or looking to set up a Self-Directed IRA? We can help. The Yieldstreet platform allows accredited investors to help diversify their retirement portfolio by investing in alternative assets with their IRA or SDIRA.

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