What Is an IRA Account & How Does It Work?

You probably want a more comfortable retirement than Social Security alone can furnish. That’s the main purpose of individual retirement arrangements, also called individual retirement accounts, or IRAs. You can also use them to help pay for a first home or qualified educational expenses. Each type of IRA has slightly different rules, but all provide tax breaks that help you save and invest in your future.

Definition

Individual retirement accounts are tax-deferred savings plans owned by individuals under guidelines set forth by the IRS. There are four main types of IRAs. Traditional and Roth IRAs are set up by individuals. A Simplified Employee Pension -- SEP -- or Savings Incentive Match Plan for Employees -- SIMPLE -- is an IRA account provided through an employer. IRAs of any type are always fully vested. That is, all contributions and earnings are the individual’s property, including contributions from employers.

General Guidelines

You can contribute up to $5,000 each year to a traditional or Roth IRA as of 2010. The limits for SEP or SIMPLE IRAs are higher. Once you are age 50, the limit increases to $6,000. Almost anyone can open an IRA, although you must beat least 21 to set up a traditional IRA. You can open an IRA at a bank, a brokerage or a mutual fund firm. The financial institution acts as trustee. If you have a “self-directed” IRA in which you manage your investments, you must designate a custodian who is responsible for administering the account. Normally, the financial institution will do this. Funds must remain in the account until you reach age 59 1/2. With some exceptions, early withdrawals incur a penalty tax of 10 percent of the amount withdrawn.

Traditional IRAs

Contributions you make to a traditional IRA are tax-deductible. Investment earnings are not taxed while they remain in the IRA. When you withdraw funds from a traditional IRA after you retire, all of the money you take out is taxed as ordinary income. You must start making withdrawals no later than age 70 1/2. The amount you must withdraw depends on your life expectancy and the amount of money in the account. You can withdraw money early for qualified educational expenses or the purchase of a first home without a penalty tax. You can also withdraw funds early to pay certain medical expenses or if you are disabled or need to pay health insurance premiums while unemployed.

Roth IRAs

With a Roth IRA, you don’t get to deduct your contributions. Earnings aren’t taxed while in the account. But provided the account has been open for at least five years and you are at least 59 1/2, money withdrawn is not subject to income taxes. There is no mandatory distribution requirement at any age. Early withdrawals are subject to similar rules as those that apply to traditional IRAs. You are limited to a total of $10,000 for home purchases. In addition, although there’s no penalty, you will have to pay income taxes on early withdrawals except when used for a first home purchase or educational costs.

SEP and SIMPLE

For the most part, SEP and SIMPLE IRAs follow the same rules as traditional IRAs, although yearly contribution limits are higher. For SEPs, your employer can put in an amount equal to 25 percent of your earnings, but no more than $49,000. Self-employed people may contribute 20 percent of net earnings up to $49,000. With SIMPLE IRAs, your employer matches your contribution up to $11,500 per year. Added to your contribution, this means an annual limit of $23,000 (as of 2010). For both SEP and SIMPLE IRAs, an employer may choose to contribute a smaller percentage each year.