What Is an IRA Account and How Does It Work?

What Is an IRA Account and How Does It Work?
An IRA can help you sock away savings for a prosperous retirement.

History of IRAs

After their creation by Congress, IRAs have undergone a number of changes up to the present day. While the original contribution limit to an IRA was 15 percent of income or $1,500, in 1981 those limits were raised to 20 percent of income and $2,000, respectively. As a result, tax returns showing an IRA contribution jumped from four percent in 1981 to 18 percent in 1986.Over time, those contribution limits continued to rise and now are indexed for inflation.

IRAs were an important development because they allowed taxpayers to control their own retirement savings. Whereas retirement accounts were traditionally business plans that were administered by companies, IRAs are personal accounts opened and funded by individuals who also have the power to choose the investments within.

Tax Consequences of IRAs

Individual retirement accounts offer a variety of tax benefits. With most types of IRAs, you initially don't pay taxes on money you put into the account. With all types of IRAs, you don't have to pay tax on the earnings generated within the account. Only when you withdraw funds from the account do those earnings become taxable. As a result, you can have decades of growth in your IRA without paying taxes on the money. If you have a Roth IRA, your contributions are taxed but you take your earnings out tax-free at retirement.

Contribution Limits and Restrictions

Opening and contributing to an IRA may be limited based on your modified adjusted gross income, which essentially is your taxable income with additional items factored back in. Anyone with earned income can contribute to an IRA, even children. As of 2015, you can contribute up to the lesser of $5,500 or the amount of your earned income into a traditional or Roth IRA. That rises to $6,500 if you are 50 or older However, you can't take a tax deduction on a traditional IRA if you are covered by another retirement plan at work, such as a 401(k) plan, or if your MAGI exceeds current IRS limits. Other forms of IRAs, such as SEP-IRAs, have their own limits and restrictions as well.

Safety

There are two levels of risk when it comes to owning an IRA account, the risk of your account itself and the risk of your investments within. Your IRA account generally is safe, even if the underlying firm goes bankrupt, because it is protected by the Securities Investor Protection Corporation. The SIPC essentially insures your account, up to $500,000, and provides for the orderly transfer to another securities firm in the event of a firm's failure.

The investments in your IRA are another story. As you choose your own investments, you bear the same market risk as any other participant. Unless you buy some type of guaranteed product, your investments bear the same potential to rise or fall in value as if you had bought them outside of an IRA.

Disadvantages

While an IRA provides many advantages, it's not as flexible as an ordinary investment account and carries certain restrictions. In addition to owing ordinary income tax on any withdrawals from a traditional IRA, you'll face a 10 percent penalty if you want your money out before age 59 1/2, with few exceptions. You're also prevented from investing in life insurance or collectibles in an IRA, in addition to any additional restrictions imposed by the firm serving as the custodian of your IRA.