Individual retirement accounts (IRAs) are long-term savings accounts that people with income earned can use to invest for the future and benefit from specific tax benefits. The IRA is primarily made for self-employed contractors who lack access to employee retirement accounts like 401(k), which companies solely offer.

A bank, an investment firm, a personal broker, or an online brokerage are all options for opening an IRA.

How does IRA Work?

Anyone with earned income—including those with 401(k) accounts via their employers—can open and invest in an IRA. The amount you can invest into your retirement accounts each year is the only limitation.

When you start an IRA, you have various financial products to pick from, such as mutual funds, exchange-traded funds (ETFs), equities, and bonds. Even self-directed IRAs, or SDIRAs, let investors take complete control over their investments. SDIRAs give investors access to a broader range of investments, including commodities and real estate. Only the riskiest investments are prohibited.

No matter when you want to retire, how you divide your income between bonds, stocks, and other investments today will significantly impact your future earnings. In fact, according to some research, asset allocation accounts for up to 90% of an investor's net return. IRAs also give you the option of changing those investments. You can move in and out of them without paying capital gains taxes, such as shifting your money from individual securities to bonds.

Although you can move the money around, you cannot withdraw it early. Because an IRA is meant for retirement, withdrawals made before the age of 59 1/2 are subject to taxes and a steep 10 percent penalty unless the funds are being used for special purposes, such as purchasing a first home or further education.

Types of IRA

Here are the four popular types of IRAs and an overview of each type.

• Traditional IRA

In the year you contribute to a traditional IRA, you can qualify for a tax deduction (up to a contribution cap of $6,000 or $7,000 if you're 50 or older). You'll have to pay taxes on the entire withdrawal amount when you later withdraw the money. You have to start making withdrawals once you turn 72.

• Roth IRA

Roth IRA offers qualified tax-free distributions but non-tax-deductible contributions. This means you can fund a Roth IRA with after-tax money and that any investment profits or withdrawals are tax-free.

Additionally, there is no required minimum distribution (RMD) for Roth IRAs. You don't have to withdraw funds from your account if you do not need money. No of your age, as long as you have a qualified source of earned income, you are eligible for Roth IRA contributions.

The contribution limitations for traditional IRAs and Roth IRAs for the tax years 2022 and 2023 are the same.

• SEP IRA

Self-employed people, including freelancers, independent contractors, and small-business owners, can open SEP IRAs.

The same tax laws that apply to regular IRA withdrawals also apply to SEP IRA withdrawals. SEP IRA contributions for 2022 are set at $61,000 or 25% of compensation, whichever is less. The maximum allowed contribution in 2023 would be $66,000.

The business owners who create SEP IRAs for their staff members can deduct contributions. The IRS taxes the employees' withdrawals as income, and they cannot contribute to their accounts.

• SIMPLE IRA

Small enterprises and freelancers are also eligible for the SIMPLE IRA. The same tax regulations apply to withdrawals from this kind of IRA as they do with traditional IRAs.

In contrast to SEP IRAs, SIMPLE IRAs enable employees to contribute to their accounts and require the company to match their contributions. Every contribution is tax-deductible, which may put the company or employee at a reduced tax rate.

In 2022, the employee contribution cap for SIMPLE IRAs is $14,000, and the catch-up cap (for employees 50 and older) is $3,000. The contribution cap and the top catch-up for 2023 are $15,500 and $3,500, respectively.

How to open an IRA

You or your spouse should have earned income through employment to start an IRA. Numerous institutions, including brokerage houses, mutual fund companies, credit unions, and banks, enable you to open an IRA. Pay attention to administration fees and minimum opening requirements to ensure you get a decent deal.

If you intend to be in control of your investments and make your own investment decisions, compare educational materials in addition to the fundamental terms of each IRA. Some businesses provide comprehensive tools to aid with market comprehension and decision-making.

IRA Vs. 401 (K)

IRAs and 401 (k) plans offer tax benefits to employees investing in their retirement. The primary distinction is in the source of the plan. Typically, employers offer 401(k) plans, with employee contributions withdrawn directly from their paychecks.

Some businesses will additionally match the contributions made by their employees. 401(k) programs have larger contribution caps, but anyone can open an IRA irrespective of whether they participate in a 401(k) plan via their place of employment. A typical IRA offers a greater selection of funds, stocks, and other securities than most 401(k) plans, which typically offer a limited selection of mutual funds and ETFs.

Bottom Line

IRAs are tax-advantaged retirement savings accounts. They function somewhat similarly to a 401(k), but an employer is not required to sponsor them. Roth IRAs, Traditional IRAs, SIMPLE IRAs, and SEP IRAs are among the different forms of IRAs. There is a contribution limitation on how much tax you can save by investing in an IRA since there are annual income restrictions on contributions to regular IRAs and Roth IRAs.