What is an IRA? A Beginner's Guide

With all the focus on the problems within the Social Security system, IRAs are becoming a very popular way for people to save for their own retirement. However, many beginning investors are hesitant to open one because they don't understand the basics. Here's a brief rundown on the facts.

IRA is an acronym for Individual Retirement Account, and an IRA is just that - an account, nothing more. The money inside an IRA can be invested in just about anything. Stocks, bonds and especially mutual funds are popular investment choices, but CDs and money market funds are also viable options. There are two main types of IRAs (Roth and Traditional), plus 3 other less common varieties, including Education IRAs and SEP and SIMPLE IRAs (which are actually employer sponsored plans). Because the last three are so rare, we'll be concentrating on Roth and Traditional IRAs.

Roth and Traditional IRAs are similar in many ways. Both are available to anyone with earned income. The contribution limit for both Roth and Traditional IRAs is $5,000 per year as of 2008, but you must have enough earned income to equal your contribution (i.e., if you have only $2,000 in earned income, you may not contribute more than $2,000 that year). Both types offer a spousal option, meaning that a couple can contribute to two IRAs even if only one spouse works. However, there are some important differences as well.

Roth IRA
The Roth IRA is also sometimes known as the "tax-free" IRA. This is not exactly true. With the Roth IRA, you pay income tax on the money upfront, and then the account grows tax-free and withdrawals are tax-free at retirement. Therefore, it's a great choice for someone who anticipates being in a higher tax bracket at retirement than they are presently. There are income limits on this type of account - in 2008, that limit is $101,000 per year for singles and $159,000 per year for couples. If you make more than that, your eligibility will be phased out. If you make more than $116,000 as a single filer or $169,000 as a couple, you are completely ineligible for a Roth IRA. Contributions may be withdrawn from a Roth IRA at any time, but investors will be penalized for withdrawals of earnings before age 59.5, except in certain cases (i.e., for a first time home purchase). There are no mandatory withdrawal requirements on Roth IRAs.

Traditional IRA
Traditional IRAs are tax-deductible, meaning you pay no taxes on the money that goes in, but the money is taxed when it's withdrawn at retirement. This is the same type of tax treatment that 401ks receive, and is particularly good for people who are in a higher tax bracket presently than they expect to be in retirement. If you do not have access to a 401k plan, there are no income limits on a Traditional IRA. However, the income limits on Traditional IRAs are relatively strict if you are eligible for an employer sponsored plan - eligibility phases out between $53,000 and $63,000 for singles and between $85,000 and $105,000 for couples. You may still contribute to a Traditional IRA in this case, but the contribution will not be tax-deductible. As with a Roth IRA, investors will be penalized for withdrawals before the age of 59.5 with a few exceptions. Also, investors are required to take minimum mandatory withdrawals from their traditional IRAs starting at age 70.5 (the government wants its tax money!).

I'll be publishing articles titled "IRAs vs. Mutual Funds: What's the Difference?" and "Where do I get an IRA?" very soon, which will have more valuable IRA information. As always, check the series introduction article for links to all of the series articles and my other articles on personal finance.