What Exactly is an IRA?
by JJ Montanaro, CFP®

What Is an IRA? 

Before I answer this question, I'll share another one that I'm asked frequently.

“What are IRAs paying?”

When someone asks me this question, I bite my tongue and think about candy bar wrappers, envelopes and garages.

I'm not kidding. I've found these analogies to be a helpful way to keep from uttering a snarky “nothing” in response to the inquiry.

Why nothing? Because contrary to what some people think, an IRA itself is not an investment. It's really just a special type of account established by the government to encourage folks to save for retirement. It's an account Uncle Sam makes more enticing by offering special tax treatment to those willing to commit for the long haul.

Those tax benefits can make IRAs an attractive way for anyone to build for the future and a mainstay for freelancers or self employed individuals that aren't covered by an employer's retirement plan.

And since it's an account and not an investment, an IRA really doesn't pay anything. An IRA is a container — a candy bar wrapper, envelope or garage, if you will. The investment stuff inside of an IRA is what provides the interest or return.

Want growth potential from your IRA? Consider purchasing market-based investments like stock mutual funds or exchange traded funds. Want safety and security? Consider choosing something like a CD. You get to make the call.

The specific IRA you select will govern the tax treatment of the account, not the returns. Let's look at two common IRA types.

Traditional IRAs

Traditional IRAs have been around since the 1980s. They provide deferral of taxes on the investment income inside the account and in certain circumstances can lower your taxes when you contribute. Unfortunately though, not everyone can deduct their contribution to an IRA. Here's a link to the IRS rules on the topic. The trade-offs? First, you generally can't use traditional IRA money before age 59 1/2 without incurring penalties. And second, you'll eventually have to pay taxes when you pull the money out.

Roth IRAs

Roth IRAs haven't been around quite as long as their traditional sibling, but they also offer some significant tax advantages. As with a traditional IRA, Roth IRAs allow you to defer taxes on the interest, dividends and capital gains generated by the investments you choose. Again, there is no tax bill for what happens inside the account from one year to the next. There are, however, some major differences.

First, with a Roth IRA, you cannot deduct your contributions. They go into the account on an after-tax basis. There are also differences when you make withdrawals. Unlike a traditional IRA, Roth contributions can be withdrawn at any time without taxes or penalties — not so for earnings, though. And if you clear a couple of hurdles, including waiting until age 59 ½, you may never have to pay taxes on any growth you experience over the life of your account. 

Make sure you're eligible

Finally, as I mentioned earlier, there are some eligibility restrictions for both traditional and Roth IRAs and some deductibility restrictions with traditional IRAs, so be sure you're eligible before you contribute to either. Check out IRS Publication 590-A for information on IRAs and Publication 560 for guidance on retirement plans for small businesses. And of course, you can always check with a qualified tax professional.

Saving for retirement? Check out what USAA has to offer:

https://www.usaa.com/inet/imco_storefront/ImcoStorefront/RetirementAccounts

Views and opinions expressed by members are for informational purposes only and should not be deemed as an endorsement by USAA.  Investing in securities products involves risk, including possible loss of principal.  

The law concerning tax and retirement plans is complex, penalties are severe, and the laws of your state may differ.  Consult your tax and legal advisers regarding your specific situation. The information contained is provided for informational purposes only and is not intended to substitute for obtaining professional financial advice. Please thoroughly research and seek professional advice before acting on any information you may have found in this article. This article in no way attempts to provide financial advice that relates to all personal circumstances.

Certified Financial Planner Board of Standards, Inc. owns the certification marks CFP^® and CERTIFIED FINANCIAL PLANNER TM in the United States, which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements. USAA means United Services Automobile Association and its affiliates.

Joseph "JJ" Montanaro is a financial planner with USAA's Military Affairs' Advocacy Group and is a CERTIFIED FINANCIAL PLANNER professional (CFP^®). He is a native of Kansas City and graduated from the United States Military Academy, West Point, New York.

Montanaro has more than twenty years of experience as a financial planner. He served in the US Army for six years on active duty and retired as a lieutenant colonel in the United States Army Reserve.

JJ's financial advice has appeared in numerous outlets including the Wall Street Journal, USA Today and the New York Times. He writes monthly personal finance columns for Military Spouse Magazine and American Legion Magazine and hosts the USAA Money Drill podcast.

 

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