How does an IRA work?


Quick Answer

An individual retirement account works by providing retirement savers certain tax benefits in exchange for limits on how and when they can use their savings. These benefits can include an immediate tax deduction as well as the opportunity for tax deferral.

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Full Answer

A person with earned income can open an IRA at any time during the year. He can also choose to fund an IRA for the prior year as long as it is done by his tax-filing deadline. An IRA can be invested in a variety of investment vehicles, such as certificates of deposit, mutual funds and individual stocks. There are income-based limits on how much can be contributed to an IRA. If someone chooses to withdraw funds early from an IRA, significant taxes and penalties can be assessed.

If a person meets certain income requirements, the money that is invested in a traditional IRA is tax deductible. When there is growth in a traditional IRA, taxes are deferred until the money is withdrawn at retirement. A Roth IRA does not provide a tax deduction at the time of the contribution. Rather, earnings in a Roth IRA can be a source of completely tax-free income in retirement if certain conditions are met.

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