What is an IRA? How does it Work?

Published June. 21, 2022

An Individual Retirement Account (IRA) is a type of investment account with tax benefits that helps you save for retirement. Depending on the type of IRA you invest in, you can make tax-free withdrawals when you retire, earn tax-free interest, or put off paying taxes until you retire. 

The sooner you start investing in an IRA, the more time you have to build up interest before you reach retirement age. But an IRA isn’t the only kind of investment account you can use to plan for retirement. And there are different types of IRAs. When planning for retirement, it’s important to know what your options are and how to get the most tax benefits. 

If your employer offers a 401(k), it may be a better option than an IRA. Anyone can open an IRA, but employers usually match a portion of what you put into a 401(k), which helps your investment grow faster. 

 

In this article, we’ll talk you through: 

  • What makes an IRA different from a 401k? (k) 
  • Types of IRAs 
  • How to choose between a Roth IRA or a Traditional IRA 
  • How to time your IRA contributions 
  • IRA reclassifications 
  • Roth IRA conversion 

 

First, let’s look at what makes an Individual Retirement Account different from a 401 (k). 

 

How is an IRA different from a 401(k)? 

When it comes to planning for retirement, IRAs and 401(k)s are the two most common investment accounts people talk about. 401(k)s offer the same tax benefits as IRAs, but not everyone has this option. Anyone can start an IRA, but a 401(k) is what is known as an employer-sponsored retirement plan. It is only available through an employer. 

 

Other differences between these two kinds of accounts are that: 

 

Employers often match a percentage of what you put into a 401(k) (k) 

401(k) contributions come straight out of your paycheck. 

401(k) contribution limits are much higher 

If your employer matches what you put into a 401(k), they are basically giving you free money that you wouldn’t get otherwise. It’s usually a good idea to take advantage of this match before looking to an IRA. 

 

With an Individual Retirement Account, you decide exactly when to make contributions. You can put money into an IRA at any time during the year, but the money for a 401(k) has to come from every paycheck. Note that annual IRA contributions can be made up until the tax filing deadline for that year, while 401(k) contributions must be made by the end of each calendar year. Learning how to time your IRA contributions can make a big difference in how much you earn over time. 

You can only put a set amount of money into a retirement account each year, and the exact amount often changes from year to year. For an IRA, the contribution limit for 2022 is $6,000 if you’re under 50, and $7,000 if you’re 50 or older. For a 401(k), the maximum amount you can put in for 2022 is $20,500 if you are under 50, or $27,000 if you are 50 or older. Since these contribution limits are different, it’s not uncommon for investors to have both a 401(k) and an IRA. 

 

What are the kinds of IRAs? 

Most people who look into IRAs have trouble figuring out which kind of IRA is best for them. For many, this comes down to Roth or Traditional. The advantages of each can change over time as tax laws and your income change, so this is a question that even experienced investors often ask themselves. 

As a side note, there are other IRA options for self-employed or small business owners, such as the SEP IRA, but we won’t talk about those here. 

As was said above, IRA contributions are not taken directly from your paycheck. That means that the money you are putting into an IRA has already been taxed. When you put money into a Traditional IRA, your contribution may be tax-deductible. Whether you can take a full, partial, or no deduction at all depends on whether you or your spouse is covered by an employer retirement plan (like a 401(k)) and how much money you make (more on these limitations later). 

Once your money is in your Traditional IRA, you won’t have to pay income taxes on investment earnings until you start taking money out of the account. This means that you get to benefit from “tax-deferred” growth. If you were able to deduct your contributions, you will have to pay income tax on the contributions as well as the earnings when you take the money out. If you weren’t allowed to take a tax break on your contributions, you’ll usually only have to pay taxes on the earnings when you take money out. It is done on a “pro-rata” basis. 

In comparison, contributions to a Roth IRA are not tax deductible. When it’s time to take money out of your Roth IRA, your withdrawals will usually be tax-free. This includes the interest you’ve earned. 

 

How to choose between a Roth IRA or a Traditional IRA 

For most people, choosing an Individual Retirement Account comes down to choosing between a Roth IRA and a Traditional IRA. Neither choice is inherently better; it depends on your income and tax bracket now and when you retire. 

Your income determines whether you can contribute to a Roth IRA and whether you can deduct contributions to a Traditional IRA. But the IRS doesn’t use your gross income. Instead, they look at your modified adjusted gross income, which can be different from your taxable income. With Roth IRAs, you can’t make contributions after your modified adjusted gross income (MAGI) reaches a certain level. 

If you’re eligible for both types of IRAs, the decision usually comes down to what tax bracket you’re in now and what tax bracket you think you’ll be in when you retire. If you think you’ll be in a lower tax bracket when you retire, putting off taxes with a Traditional IRA will likely let you keep more of your money. If you expect to be in a higher tax bracket when you retire, using a Roth IRA to pay taxes now may be a better idea. 

The best type of account for you could change over time, but making a choice now doesn’t lock you into one option forever. So, as you plan for retirement, think about where you are now and where you’d like to be then. It’s a good idea to look at your financial situation from time to time, especially when you go through big changes like getting a new job, losing a job, getting a promotion, or starting a side business. 

 

IRA contributions: why earlier is better 

No matter which type of IRA you choose, it helps to understand how the timing of your contributions affects your investment returns. You can make a maximum contribution early in the year, contribute over time, or wait until the deadline. By making your contribution as early as possible, you can spend the most time in the market, which could help you earn more returns over time. 

 

What is a change in the way an IRA is used? 

You might put money into an IRA before you start filing your taxes, and you might not know exactly what your Modified Adjusted Gross Income will be for that year. So, you might not know if you’ll be able to put money into a Roth IRA or if you’ll be able to get a tax break for putting money into a Traditional IRA. 

The IRS sometimes lets you change how your IRA contributions are used. A recharacterization moves your contributions from a Traditional IRA to a Roth IRA or from a Roth IRA to a Traditional IRA, taking into account any gains or losses that go along with them. Most of the time, a Roth IRA is changed into a Traditional IRA. 

Most of the time, you don’t have to pay taxes on a recharacterization if the amount you change doesn’t include money you lost or doesn’t include money you gained. 

 

Here are three times when you might want to change the way you talk about something: 

If you put money into a Roth account during the year, but then found out that your income was high enough to lower the amount you could put in or stop you from putting anything in at all. 

If you put money into a Traditional IRA because you thought your income would be too high to be able to put money into a Roth IRA, but your income ended up being lower than you thought it would be, you can get your money back. 

If you put money into a Roth IRA, but when you’re filling out your tax return, you realise that you’d be better off with the immediate tax deduction that a Traditional IRA contribution could give you, you can switch to a Traditional IRA. 



You can’t change the type of money more than your maximum annual contribution. To recharacterize, you have until the tax filing deadline each year, unless you file for an extension or an amended tax return. 

 

What does “Roth conversion” mean?

A Roth conversion can only go in one direction. When money is moved from a Traditional IRA to a Roth IRA, it could be a tax-payable event. There is no way to switch from a Roth to a Traditional account. It’s different from a recharacterization because you don’t change the kind of IRA you put money into for that year. There is no limit on how much can be converted, so anyone who wants to can convert as much as they want. In our Help Center, we talk more about Roth conversions. 

 

Tenjin AI can help you plan for your retirement. 

Tenjin AI can help you manage your investments whether this is your first time investing or you already have an IRA and a 401(k). After you answer a few questions, we’ll tell you how much you need to save each year and where you should put it, including whether you should use a Traditional or Roth IRA. You can connect other accounts to your Tenjin Ai account, get AI driven rebalancing to your portfolio, and then let us handle the rest. We’ll take care of the little things so you don’t have to.





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