Banking 101: What is an IRA?

An IRA is an Individual Retirement Arrangement (also called an Individual Retirement Account) that allows individuals with earned income to make contributions to provide money for retirement. The Internal Revenue Service defines earned income for tax purposes, and it is usually money received from a job or self-employment such as wages, salaries, bonuses, commissions, or tips. Long-term disability, union strike benefits, and payments from certain deferred retirement compensation arrangements (in some cases) may also be considered earned income.

Many financial experts estimate a person needs up to 85% of their pre-retirement income in retirement. Even participants in a company-sponsored savings plan such as a 401(k) plan might not be able to accumulate all the savings needed for retirement, and an IRA can help with this goal. IRAs can be set up with a bank or other financial institution, life insurance company, mutual fund, or stockbroker.

Basics of How an IRA Works

With an IRA, money received from working is contributed during the income-earning years and withdrawn later in life, usually upon retirement. An individual can save for their future retirement using an IRA and receive potential current tax advantages such as deductions from taxable income or deferred taxes on the plan’s earnings. Income limits, contribution limits, withdrawal requirements, and other rules regarding IRAs are set by Congress.

You can contribute to both a company sponsored 401(k) plan and an IRA. An IRA can help supplement your employer-sponsored plan and may allow you to expand your range of investment choices beyond the 401(k). If your employer doesn’t offer a company-sponsored retirement plan, an IRA may offer you higher tax-deductible contribution limits.

Money in an IRA can be withdrawn in retirement to supplement funds from Social Security and other retirement plans. There are special situations where the money may be withdrawn before retirement and your tax advisor or financial planner can help you with strategies for your situation.

There are three main types of IRAs – Traditional IRA, Roth IRA, and Rollover IRA. With each type, the tax benefits allow your account to grow through compounding more quickly than they might in a taxable account. There are also specialized IRAs geared for employers and those who are self-employed.

Traditional IRA

A Traditional IRA allows you to save for retirement during your working years, using contributions from your earned income. The law allows you to take a deduction on your tax return for the amount you contribute to your IRA, which reduces the amount of your taxable income in that tax filing year. There are limits on contributions and deductions based on several factors, including whether you or your spouse (if any) are participants in a workplace plan. Consult with an accountant and/or financial planner for more information about specific IRS rules and how a Traditional IRA can help your tax situation and retirement planning.

In general, an IRA allows you to defer the taxes on income earned while in a higher tax bracket to a time when you may be in a lower tax bracket. Part of the logic behind the Traditional IRA is that you may be in a higher tax bracket while working than after you retire.  When you retire and begin to take distributions (withdrawals) from the funds in your Traditional IRA, if you are in a lower tax bracket than when you were working, you would pay less in income taxes on the money than you would have paid during your working years.

Because money wasn’t taxed when it was contributed to the Traditional IRA, Required Minimum Distributions (RMDs) apply during the retirement years. The RMD represents an amount of money you must take from the account whether you need it or not, and it is taxed at your current tax rate. Your tax advisor or financial planner can help you determine if you are subject to RMDs and plan accordingly.

Roth IRA

A Roth IRA allows you to save for retirement using contributions from earned income that you already paid taxes on.  There is no income tax deduction allowed for contributions to a Roth IRA. Your Roth IRA funds may potentially grow tax-free, and when certain conditions are met, your withdrawals may also be tax-free. Consult with an accountant and/or financial planner for more information about specific IRS rules and how a Roth IRA can help your tax situation and retirement planning.

If you think your tax rate in retirement might be the same or higher than when you were working, a Roth IRA could help protect you. The government already received the tax revenue from the funds when you earned it and contributed to the Roth IRA, so there is no tax due on the distributions and no required minimum distribution.

Some people contribute to both a Traditional IRA and a Roth IRA. This allows them to withdraw money from each type of account in retirement to have a blend of taxable and non-taxable income.

Rollover IRA

A Rollover IRA is an account used to move money from qualified employer-sponsored retirement plans such as a 401(k) plan into an IRA. This type of transaction often happens when a person leaves a company where they participated in a company-sponsored retirement plan.

Some people change jobs several times during their working life, and their Rollover IRA could eventually contain funds from multiple previous company sponsored plans. When done correctly, the funds rolled over to a Rollover IRA keep their tax-deferred status and don’t trigger taxes or early withdrawal penalties.

Generally, money from a qualified retirement plan could be moved directly from one financial institution to another, or you could withdraw the funds and deposit the distribution into another retirement plan or IRA within 60 days. If you don’t roll over the distributed funds in the allowable timeframe, you would be subject to taxation and a potential early distribution penalty. Consult with an accountant and/or financial planner for more information about specific IRS rules and how a Rollover IRA can help your tax situation and retirement planning.

The information contained in this article should not be construed as financial, legal or tax advice, and may not be reflective of terms and features currently offered by Enterprise Bank. Please contact us for details on current product offerings and rates.

To learn about products and services offered by Enterprise Bank including IRAs, please visit https://www.enterprisebanking.com. If you would like to speak to an Enterprise Banker about opening an IRA account, we invite you to call us at 877-671-2265 or visit one of our convenient branch locations.

For more information about IRAs, visit the Internal Revenue Service website at irs.gov/retirement-plans/individual-retirement-arrangements-iras.