A guide to IRAs: Tax-advantaged investing accounts that help you save for retirement

• An Individual Retirement Arrangement (IRA) is a type of retirement account designed for individuals that provides various tax advantages. There are several kinds of IRAs.
• Depending on which type of IRA you have, you'd contribute either pre- or post-tax dollars and invest the funds in various assets.
• IRAs come with more investment flexibility than 401(k)s, which are employer-sponsored plans.

An Individual Retirement Arrangement, or IRA, is a type of retirement account for individuals you can use to both save and invest for retirement.

Many people use IRAs to augment other retirement accounts and to leverage their many tax benefits. Depending on the type of IRA you choose, which will be covered later, contributions may be tax-deductible or you may enjoy tax-free withdrawals in retirement. "IRAs are simple and are an extremely easy investment plan to help save for your retirement years," says Wilson Coffman, president at Coffman Retirement Group.

How do IRAs work?

With an IRA, you'll contribute money to the account as desired throughout the year. You can then use the funds to invest in various assets, including mutual funds, index funds, stocks, bonds, ETFs, and other investments. As those assets increase in value, your IRA's value rises as well.

To open an IRA, you'll go through a brokerage or local bank. "IRAs are extremely easy to establish and set up," Coffman says. "Most banks offer an IRA and any brokerage outfit will offer IRA accounts. There are also many investment firms, like Fidelity, that can offer investment platforms for online retirement savings accounts as well."

Once set up, you'll then fund the account using bank payments, checks, or, if you have other retirement accounts, a rollover.

Quick tip: To roll over funds from another retirement account, you can do a direct rollover or trustee-to-trustee transfer by contacting your existing plan's administrator. You can also take a distribution and deposit it in your new IRA yourself, but it must be done within 60 days.

IRA contribution limits

The IRS has set contribution limits on IRAs, but the exact amount depends on your age, your taxable compensation for the year, and the type of IRA you've established.

Here's how IRA contributions break down for 2021:

With Roth IRAs, you may not be able to contribute up to the full maximum. Here's how your modified AGI and tax filing status can impact your contribution limits on these accounts:

How IRAs are taxed

The tax treatment of an IRA depends on the type of account. With traditional, SIMPLE, and SEP IRAs, contributions are tax-deductible, and you fund the account with pre-tax dollars, meaning you won't pay taxes until you withdraw money later on.

With Roth IRAs, you contribute post-tax dollars - or money you've already paid income taxes on. This allows for tax-free withdrawals in retirement. "IRAs are either taxed at the beginning or the end," says Christy Matzen, director of financial planning at Zoe Financial. "When you make a contribution, you can pay tax on the dollars before you put it into the account - this will let you take the money out tax-free, or you can take a tax deduction when you make the contribution, but then the money will be taxed when you take it out."

Quick tip: On all IRA types, you'll want to wait until you're at least 59 ½ to start withdrawing funds. Withdrawals before this point face a 10% penalty. There are some exceptions on Roth IRAs if you've funded it with a rollover, so talk to your tax advisor if you're planning to withdraw early from this type of account.

Types of IRAs

There are several types of IRAs, each with their own unique contribution limits, taxation structure, and use cases.

The main four include:

• Traditional IRA: This type of IRA is funded with pre-tax earnings. Contributions are tax-deductible, and you'll pay taxes on the funds when you withdraw them in retirement. They're typically best if you expect your tax bracket to be lower in retirement.
• Roth IRA: With Roth IRAs, you fund the account with after-tax earnings. This allows the money to grow tax-free, and you'll pay no additional taxes upon withdrawal. They're a good option if you know your tax bracket will be higher in retirement.
• SEP IRA: SEP IRAs are for self-employed professionals or small businesses. They have much higher contributions than traditional and Roth IRAs and are taxed upon withdrawal.
• SIMPLE IRA: SIMPLE IRAs are another type of small business retirement account. These are also funded with pre-tax dollars and taxed once you withdraw money.

Most people find themselves choosing between traditional and Roth IRAs. According to Clark Howard, author and host of The Clark Howard Podcast, future taxes should play a big role in deciding between the two.

"The biggest difference between a traditional IRA and a Roth IRA is the treatment of taxes," Howard says. "ln general, tax rates are likely to go up over the years no matter which political party is in power. That means it may make more sense to skip the tax deduction you get up front with a traditional IRA to avoid tax later by investing with a Roth IRA."

Pros and cons of IRAs

IRAs can be a good way to save for retirement, but they're not perfect. As with anything, they come with both pros and cons.

On the one hand, they come with many tax benefits and can allow you to invest your funds in a variety of assets. On the other, there are age limits on when you can withdraw funds (or face a penalty), and in many cases, the contribution maximums may be lower than on other types of retirement accounts. For example, 401(k)s allow you to contribute up to $19,500 annually.

IRA vs 401(k)

401(k)s are another popular type of retirement account, but they're quite different from IRAs. Here's a quick look at their main differences:

The financial takeaway

An IRA is just one of many retirement account options, and there are several types to choose from. The right choice will depend on your individual retirement goals and timeline, as well as your expectations for future taxes.

If you're not sure which retirement account or type of IRA to go with, consider speaking to a financial advisor or tax professional. They can point you in the right direction.