How Does an IRA Make Money?

How an IRA Invests

An IRA is an Individual Retirement Account. This is a tax designation, not a specific investment in a specific thing. The owner of the IRA can invest in just about whatever they want. This includes any kind of mutual fund, bonds or cash investments. The IRA designation only regulates how contributions, growth and distributions of the IRA are taxed or not taxed.

Choice Between Traditional IRA and Roth IRA

When an investor opens an IRA they must decide whether they want a Traditional IRA or a Roth IRA. Both are individual retirement accounts but differ in how they give tax breaks to investors. There are also some differences in rules regarding contributions and distributions. Investors should check with the IRS every year to see if they are eligible to open and contribute to a Traditional IRA or a Roth IRA. There are strict income limits that sometimes change from year to year.

How an IRA is Different

An IRA grows the same way any other investment grows. Stocks and bonds appreciate and gather dividends. Money market accounts and other cash investments accrue interest. One of these accounts that is also an IRA is different because of the tax advantages. Over a long period of time the tax savings are significant.

Traditional IRA Tax Benefits

With a Traditional IRA, qualified contributors can deduct their contribution from their taxes in the year they make the contribution. This makes their deposit tax free money. The Traditional IRA grows tax deferred through the years. Any dividends or taxable growth are reinvested tax free. When distributions are taken from a Traditional IRA the funds are taxed at the owner's current tax rate. This works to the advantage of owners who are in a lower tax bracket at retirement than they were while they were working.

Roth IRA Tax Benefits

With a Roth IRA, qualified contributions are made with money that has already been taxed. There is no tax break during the year the contribution is made. However, a Roth IRA grows tax free through the years. When distributions are taken from a Roth IRA those funds are also tax free.

IRA Tax Savings

The tax savings realized by both the Traditional IRA and Roth IRA are considerable. An investor could contribute to an IRA for 50 years or more. Taxes on the growth of the investment can be in the tens of thousands or hundreds of thousands of dollars. IRAs allow investors to avoid some or all of these taxes when they retire.