What Is an IRA and Which Type Should You Choose?

Time To Read 3 MIN READ

"An individual retirement account is a special type of account that allows you to save money for retirement and reap tax benefits for doing so. An IRA isn't an investment itself, but rather an account that holds other investments. The Internal Revenue Service allows you to invest the money in your IRA in a range of options, including stocks, bonds, mutual funds and certificates of deposit. However, you can't invest in collectibles.

Tax Benefits

IRAs come in two general types traditional IRAs and Roth IRAs. Traditional IRAs offer a tax deduction for contributing, assuming you're eligible, which means each dollar you put in lowers your tax bill for the current year. But, you have to pay taxes on the money when you take it out. Roth IRAs offer the reverse: You won't receive a tax deduction for contributing, but you will get your distributions in retirement tax-free -- including the earnings on your investments. For both types of IRAs, the money grows tax-free as long as it remains in the account.


To contribute to any type of IRA, you need to earn income during the year. Both traditional IRAs and Roth IRAs are accounts you open on your own. However, for a traditional IRA, if you're eligible to contribute to an employer plan through your job, like a 401(k) or 403(b), you can't deduct your contribution if your income exceeds the annual limits, according to IRS Publication 590. For example, in 2014 if you are single, covered by a 401(k) plan and your modified adjusted gross income (calculating by only reducing your income by certain deductions) exceeds $70,000, you can't claim a tax deduction for contributing to a traditional IRA. For a Roth IRA, if your income exceeds the annual limits, you're not allowed to contribute at all.

Contribution Limits

The IRS puts limits on how much you can sock away in an IRA each year, capping your contributions at the smaller of your compensation for the year or the annual limit, which is $5,500 as of 2014. Your compensation refers to the amount of income you make from working, such as your wages, salary or bonuses. It doesn't include interest income or money you make from investments. If you contribute more than your limit, the IRS imposes a penalty each year that the excess contribution isn't corrected. To correct an excess contribution, you must withdraw not only the contribution, but any income earned on it. For example, if you put in $1,000 too much and it grows to $1,050 before you correct it, you must withdrawal $1,050.

Penalties for Early Withdrawals

To discourage people from raiding their retirement savings, the IRS imposes an extra 10 percent tax -- on top of the ordinary income taxes -- on the taxable portion of your withdrawals taken before age 59 1/2. For example, if you're in the 15 percent tax bracket and you take out $1,000 from a traditional IRA at age 30, you'll owe $150 in income taxes and $100 in tax penalties. The IRS does permit a few exceptions from the penalty, including certain medical expenses, higher education costs, a permanent disability and up to $10,000 to buy a first home, but a general financial hardship won't save you from the penalty."