What is a retirement account?
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Key takeaways
These accounts are structured to encourage long-term saving by offering tax advantages that help your money grow over time.
Options like traditional and Roth retirement accounts vary in how and when contributions and withdrawals are taxed, making it important to choose based on your income, timeline, and goals.
Contributing regularly to a retirement account allows compound growth to work in your favor, helping you build more savings over the long term — even with smaller contributions.
You work hard all your life so you can enjoy a fulfilling, carefree retirement. That’s only possible if your retirement savings are sufficient to support your post-employment lifestyle. If you dream of cruises, vacations, and pursuing hobbies, you may want to plan your retirement savings accordingly.
Many individuals open a retirement account in addition to an employer-sponsored savings plan. It’s a way to ensure you have the money you need to truly enjoy life as you age. Anyone can open a retirement account and begin working toward a secure, comfortable future.
In this guide, we’ll share all there is to know about opening an individual retirement account. Continue reading to begin saving for the retirement you deserve.
Retirement account basics: What you need to know
A retirement account is a dedicated savings and investment account that helps individuals and couples save for retirement. They are sometimes called IRAs or individual retirement arrangements.¹
Traditional IRAs are unique from a 401(k) as they do not need to be tied to an employer.² Traditional IRAs are also beneficial because you can deduct your contributions from your income. As a result, you’ll pay lower annual income taxes, and your earnings will not be taxed until they are withdrawn. This is known as a tax-deferred investment account.³
Upon withdrawal, you will pay ordinary income tax on the amount withdrawn. Traditional IRAs typically have a Required Minimum Distribution or RMD. This is the minimum amount you must withdraw annually when you reach the age of 73.
There may be penalties if you withdraw your funds prior to age 59½, often 10%. Your state may also impose a tax penalty for early withdrawal.⁴
A traditional IRA is a good option for those who expect to remain in their current tax bracket. There may be better options for those who expect to be in a higher tax bracket during retirement.
Understanding how IRAs are taxed can help you decide what account best suits your retirement needs.
Self-managed vs. managed IRAs
You can open a traditional retirement account at a variety of financial institutions, including your bank or credit union.
Some institutions allow you to choose your own investments for a customized portfolio. Such accounts are referred to as self-directed retirement accounts. You might also hear them called self-managed IRAs or self-directed IRAs.
In many cases, however, you may wish to have support in managing your investments. A managed IRA is a retirement account that buys, sells, and trades investments for you, with no need for you to take action. A money manager or broker makes choices about how your funds are managed.
Self-directed retirement accounts allow you to invest in a more diverse range of products. For example, real estate or private equity, or even gold and other precious metals in the case of a gold IRA. Managed IRAs tend to be limited to traditional investments such as stocks or mutual funds.
Both options involve some amount of risk, as all investments do. The deciding factor is how much control you personally wish to have over your portfolio.
Types of individual retirement accounts
You are not limited to opening a traditional IRA. Depending on your preferences, there are several types of retirement accounts to consider.
What is a Roth retirement account?
Unlike traditional IRAs, individuals fund Roth IRAs with after-tax dollars. If you hold a Roth IRA account for at least five years, withdrawals will be tax-free. However, Roth IRAs are not tax deductible like traditional IRAs. Contributions will not impact your annual income tax return.⁵
Roth IRAs can be a good investment option for those who expect to be in a higher tax bracket during retirement. As the taxes will be paid up-front at a lower rate, you may be able to enjoy your savings while mitigating tax implications.
Understanding the differences between a Roth IRA vs. a traditional IRA can help you decide what account best fits your needs.
What is a tax-free retirement account?
A tax-free retirement account (TFRA) is a permanent cash-value insurance policy, not a qualified retirement plan. You might hear them called Section 7702 plans. They are not retirement accounts because the payout goes to a beneficiary, not to you.
Like a Roth IRA, a TFRA is funded using after-tax dollars. However, the IRA does not impose a restriction on withdrawals from a TFRA account. Furthermore, a TFRA account has a “floor,” which means you cannot lose funds if the market drops. They are not tax-deductible.
What is a SEP retirement account?
SEP stands for Simplified Employee Pension. You might sometimes see them referred to as SEP-IRAs. They refer to traditional IRAs that allow an employer to contribute to your retirement.
With a SEP, your employer can pay up to 25% of your pay toward your retirement account. The business can deduct these contributions and may be eligible for a tax credit. Furthermore, there is no tax on investment earnings with a SEP account.⁶
An individual cannot open a SEP retirement account on their own. They can only be opened by sole proprietors, partnerships, and corporations. Many self-employed, small business owners set up such accounts to prepare for retirement. Administrative costs tend to be low, and there is a great deal of flexibility for contributors.
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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.
Sources:
- https://www.raisin.com/en-us/retirement/savings-accounts-for-retirement-strategy
- https://www.raisin.com/en-us/retirement/pension-vs-401k
- https://www.raisin.com/en-us/retirement/pension-vs-401k
- https://www.irs.gov/retirement-plans/traditional-iras
- https://www.irs.gov/retirement-plans/roth-iras
- https://www.irs.gov/retirement-plans/plan-sponsor/simplified-employee-pension-plan-sep
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