What is an IRA?

An Individual Retirement Account, or an IRA, is basically a kind of retirement plan that is maintained individually. Technically, these retirement plans can be described as defined contribution plans because you do not know the exact value of the plan once you retire. IRAs have a provision in the Internal Revenue Code in Section 408 which states that you need to individually arrange your retirement. You should note that the IRA is not an investment; rather, it is a fund that can be sheltered from taxes.

To give you a better understanding of an IRA, think of your IRA account as a bucket. You can use the money in your IRA account for virtually any transaction but you should note that the money you use to either buy or sell any investment should stay inside the bucket for a specified length of time. The major advantage of transactions using your IRA account is that taxes are deferred. This means that you do not have to pay any taxes from any profit at the end of the year when you use your IRA account for these transactions. Instead, you will only need to pay the taxes upon the withdrawal of your funds from IRA. This can prove to be more profitable for you because tax-deferred investments can grow at a more rapid pace compared to investments where you need to pay taxes at the end of the year.

There are three types of IRAs: the deductible IRA, the non-deductible IRA, and the Roth IRA. It is important to understand each of these in order to choose the best one for you.

The Deductible IRA

This kind of IRA is probably the most preferred of the three because it provides several benefits that are not present in other IRAs. For example, you do not need to pay taxes for the money you invest until you decide to withdraw. In addition, any profit you can derive from your investments such as interest, capital gains, or dividends are also tax-deferred.

The Non-deductible IRA

However, many people are not eligible to take advantage of the deductible IRA so they choose the non-deductible IRA instead. In the non-deductible IRA, you are required to pay taxes for the amount of money you contribute to your IRA every year. You need to file IRS form 8606 and then keep an accurate record of your file. This is because it is possible that you will need to pay twice upon withdrawal if you don’t have the papers to show that you paid taxes for the income you earned for a certain year.

Roth IRA

The non-deductible IRA proved to be an inconvenience to many people. So the Roth IRA, which is named after Senator William Roth, was devised as an alternative. It provides several benefits that are not present in the non-deductible IRA and even the deductible IRA. One of its greatest benefits is that you do not have to pay any taxes upon the withdrawal of your IRA funds.

Overall though, IRAs are a great way to plan your retirement. You should never treat your IRA account as an expense; instead, it should be treated as an investment in your future.